Stockwatch: Tullow Oil shares at tipping point

Does a 23% bounce in the beleaguered shares of oil explorer & producer Tullow Oil signal a turning point? Tullow had slumped from 1,600p in 2012 to a recent low of 167p, but has just surged to over 205p after the company announced on 1 October that banks remain supportive amid low oil prices.

Oil prices have also gained a respite as the US rig count has plunged, as if reduced US supply means the oil downturn is bottoming out. Oil price expectations are always liable to turn, which largely explains the wide range of brokers' price targets, from 168p to 590p.

Tullow has effectively made itself hostage to oil prices after running up substantial debts, the context not dissimilar to Glencore - in terms of producers' hubris after boom years and low interest rates. Yet high debt usually erodes equity value as earnings/cash are diverted to pay interest charges, and speculation erupts over covenant and repayment risks. Only time will tell what the US Federal Reserve does with interest rates, a small increase being the current expectation.

Debt looks likely a persistent feature

Tullow's interim statement showed just over $4 billion (£2.6 billion) of debt, virtually all longer-term, and $488 million cash, for net gearing of about 93%. The income statement showed $96.5 million operating profit wiped out by $81.6 million net finance costs and a £25.1 million hedging loss. Yet banks remain supportive, the group having total facilities of $2.1 billion including the cash, and no near-term maturities. For the time being this has scotched liquidity fears and sent the shares up.

The table shows the consensus expecting a bounce-back into profits, project timing being a key contributor. However, some analysts still expect gearing to pass 100% of net assets this year. Investec estimates it will stay above 90% until the turn of the decade, even assuming a higher oil price of $70/barrel, as the net present value of Tullow's interest costs is estimated at $1.3 billion or 92.5p a share.

The financial statements don't really clarify the structure of charges, although note 22 "financial instruments" in the 2014 annual report cites a weighted average effective interest rate of 6.5% on fixed interest and 6.7% on variable. Investec suggests Tullow's reserve-based lend (i.e. lending secured this way) has floating charges, while its bonds have fixed coupons - i.e. as and when rates rise, the former will become more expensive, while the cost of refinancing the latter will also rise. Such concerns ebb and flow with oil prices - the sense of a possible trough implying Tullow shares are at a tipping point.

Iran to resume oil exports; Saudi cuts prices

The extent of oil glut is shown by virtually no premium for risk amid current turmoil in the Middle East - which is historically unprecedented. The World Bank reckoned in early August - with prices similar to today - that lifting sanctions on Iran's oil exports is likely to push prices down by a further $10 next year.

Indeed, there is much capacity after the commodities "super-cycle", e.g. US shale-energy, Canada's oil sands, the prospect of more Mexican production making the Americas less dependent on Middle Eastern supplies. Moreover, South America has vast oil reserves. In such a context OPEC producers might have been expected to limit supply, but Saudi Arabia's latest move to cut prices shows the cartel breaking down into competition - with a radical agenda by Saudi to stimulate Asian economies and retain market share. Yet oil's capricious nature is shown by a firming after Russia indicated it wants to meet other oil producers, coinciding with the fall in US rig count.

Stock being shorted

On debt and oil price considerations, risk weighs to the downside in an earnings sense. This is the logic for short-selling with hedge fund Lansdowne Partners representing 2.51% of 5.25% of the issued share capital out on loan. It's always worth considering the bear case behind a significant short position, and end-September data showed Lansdowne Partners maintaining its 2.51% short position with four other asset managers increasing theirs slightly. Yet a significant short position can accentuate an upturn - like possibly now - if and when some shorters close out. Sainsbury's jumped 13% last week, merely in a sense it might be succeeding amid supermarkets' competitive pressures; there being over 10% of the stock out on loan. Similarly, Home Retail Group recovered strongly in 2012/13 after it became the most-shorted stock on the London market, although it has de-rated somewhat again. The key point being, the more crowded a trade becomes the more scope for a sharp reversal.

Tullow's projects have attractions

With 88% of last year's revenues deriving from western/northern Africa, the stock has an "emerging markets" risk/profile - underlined also by Tullow's historic problems in Ghana where there have been various issues, lately a border dispute with Ivory Coast affecting the key Tweneboa-Enyenra-Ntomme, or TEN, project.

Yet this is now expected to deliver first oil and a cash flow boost from mid-2016, which should augment the story going forward. West African production is within guidance and the second-half period offers exploration in Suriname, Norway and Kenya. The operational story is fair, if lacking the excitement of past years where blockbuster discoveries transformed Tullow's asset base, creating an aura around the shares, as if management "made its own luck".

Yet hubris appeared to be the result, in assuming so much debt without due regard to oil's cyclicality. Nor is there any material director/senior manager share buying around these depressed levels, although in fairness the chief executive and company secretary own 6.4 million and 2.04 million shares respectively, although interestingly the finance director has the lowest ownership with 14,800 shares.

Oil price movements likely to dictate

Tullow's operations appear to be making overall progress, however attention has shifted from exploration to the financial dynamics of debt under lower oil prices. If you believe they are stabilising, with wider deflationary fears overdone, this stock is a prime means to play the new scenario - but mind how equally, if oil weakens again, bears will be back. It's easy for investors to be lured by a sense of "how the mighty have fallen", while Tullow is really material for alert traders.

For more information see tullowoil.com.