Join our community of smart investors

Uncertain outlook for Tullow Oil

As the long-term sector outlook clouds, we suggest binning shares in one of its weaker constituents
November 8, 2018

The risks associated with investing in oil stocks are increasing. In the next few years, some analysts expect crude demand will peak, leaving an uncertain (though probably volatile) trajectory thereafter. What's more, if the world is to have a chance of meeting the de-carbonising targets of the Paris Agreement, it must step away from fossil fuels fast. At the same time, technology and moves towards cleaner industrial sources of energy, carbon pricing and vehicle electrification are only likely to intensify. This makes it ever more important for oil companies to be financially flexible

IC TIP: Sell at 221p
Tip style
Sell
Risk rating
Medium
Timescale
Long Term
Bull points

De-gearing

Stronger oil price

Bear points

Large interest payments

Unclear long-term strategy

Exploration focus

Poor track record

Don’t take our word for it: ask Tullow Oil (TLW). Within the FTSE 250 company’s annual report, climate change is cited as a principal source of strategic and financial risk, given the impact a shift to alternative energy sources might have on oil prices. The group’s mitigation – “robust planning of strategy”, “strict capital allocation” and a hedging programme – aren’t what you’d call economic moats. The comments highlight the benefit of financial flexibility in this environment, but this is something Tullow boasts little of. 

While some supermajors (such as Repsol or Shell) have the will, financial clout and technical capacity to transition their traditional energy focus, others, such as Tullow Oil (TLW), are saddled with debts that increase the risks associated with the uncertain outlook.

In terms of market capitalisation, Tullow is the largest London-listed ‘independent’ (that is, after BP and Shell). It also has one of the most indebted balance sheets of any company in the sector, despite last year’s $750m (£576m) rights issue at 212p a share. And while Tullow’s notes, bonds and facilities do not mature for several years, such is the debt that Panmure Gordon calculates that interest payments will hoover up almost $0.5bn of operating profits between 2018 and 2020. 

Interest payments are not the only thing eating into bottom-line profits. Tullow is having to deal with a $200m hit from litigation results. The company has also made a commitment to exploration, on which it plans to spend up to $150m a year from 2019. True, if money can be recouped from such investment – as is the case with the farm-out of the group’s Ugandan development for $250m – the outlay won't seem onerous. But 'high-impact' wildcat drilling is a high-risk use of capital for a company with big debts. This was highlighted by Tullow's recent failure to find anything at the Cormorant-1 exploration well offshore Namibia.

One could argue that Tullow is merely pursuing its long-term mandate to find new sources of oil, but there are better capitalised, dividend-paying choices, which also happen to be investing in the world's growing appetite for lower emissions liquids.

A focus on exploration is also a bet on the unknowable, and between discovery, appraisal, development and payback, hundreds of millions of dollars and years of patience are required. Climate change, declining oil demand and the risk of stranded assets further strain this long-cycle business model.

TULLOW OIL (TLW)   
ORD PRICE:221pMARKET VALUE:£3.07bn
TOUCH:221-221.4p12-MONTH HIGH:279pLOW: 162p
FORWARD DIVIDEND YIELD:NILFORWARD PE RATIO:12
NET ASSET VALUE:185¢*NET DEBT:119%
Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)**Earnings per share (¢)**Dividend per share (¢)
20151.61-1.30-44.9nil
20161.27-0.91-2.3nil
20171.72-0.3014.1nil
2018**1.930.4729.9nil
2019**1.970.4823.4nil
% change+2+1-22-
NMS:7,500   
BETA:1.82   

£1=$1.29.

*Includes intangible assets of $2.0bn, or 145¢ a share

**Panmure Gordon forecasts, adjusted pre-tax and EPS numbers