Turkey of the week: Take profits on this oil firm
By
Paul Hill Dec 04, 2009
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The oil price has been a volatility trader's dream over the past two years. After rising to $145 per barrel in mid-2008, the price crashed to below $40 in December. It has since doubled, leading some gung-ho pundits to claim that it will soon gush through the $100 barrier.
This seems unlikely, as the fundamentals remain poor. Demand from heavy petrochemical users is lacklustre, inventories are at record levels, and Opec has plenty of spare capacity. So I think oil should be trading at around $50-$60 per barrel. Anything higher is pure speculation.
So what about Tullow Oil, which has seen its shares nearly triple over the past 12 months? This independent oil and gas explorer was founded in 1985 by the current CEO, Aidan Heavey, and has completed two key deals over the past five years. First it bought the North Sea interests from BP in 2000 and then it purchased Energy Africa in 2004. That deal gave it a substantial footprint in west Africa. The firm's existing production is pumping oil at about 58,000 barrels per day – 66% oil and 34% natural gas.
Tullow Oil (LSE: TLW), rated a BUY by Nomura
However, even this output, along with the development of the associated fields, only accounts for about 25% (or £3) of the company's share price. The other 75% of Tullow's valuation is built on the bullish estimates being applied to its risky exploration licenses and its reserves located in frontier countries such as Sierra Leone, Ghana and Uganda.
Tullow's business model is built on it being a 'wild-catter'. It explores and discovers new hydrocarbon deposits, and then off-loads the rights on to the oil majors, who later make money from them. For instance, last Tuesday Heritage Oil, Tullow's partner in Uganda, disposed of its entire interests to Eni of Italy for $1.5bn. That works out at about $5 for each proven, but not yet developed, barrel of oil. Although this might seem low, it reflects the enormous subsequent infrastructure costs associated with developing such inhospitable fields. These include a £2bn export pipeline to the coast, along with a new £5bn refinery.
In fact, this deal provides an excellent reference point for estimating the value of Tullow's future drilling rights in the region. By combining the $5 per barrel yardstick with an assumed crude price of $55 per barrel, I would value this FTSE 100 wild-catter at about £9 per share. That's 25% below today's price.
So, although the firm owns several quality assets and has of late had a terrific run of exploration successes, it's time to take profits. Plus there is a danger that if the board fails to offload some of its licenses then it may have to tap shareholders for further funds – given its net debt (adjusted for cash balances) of £664m and chunky capital expenditure plans.
Worse, there is a chance of political interference in some of its wild-west operating territories. For example, a local government may decide to renegotiate Tullow's contracts after Russia's success in bullying BP and Shell.
Recommendation: SELL at £12.94
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments
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