Questor share tip: Tullow Oil shares are interesting after write downs

Tullow Oil
849½p-5½
Questor says BUY

TULLOW Oil [LON:TLW], the African-focused oil and gas producer, announced some painful write-offs yesterday as exploration wells came up dry. However, on closer examination the company is generating plenty of cash and financing is in place to increase production which could send shares higher.

The company reported a $415m (£243m) pre-tax write-off during the first half of 2014 after wells drilled in Mauritania, Ethiopia and Norway failed to come up with the desired results. The company also said it made a loss of $115m disposing of oilfield assets during the first six months of the year.

The exploration failures mark a tricky two-year period for Tullow during which the shares have fallen by more than 40pc from highs of more than £14 in June 2012. None the less, the company has maintained dividend payments during this period and this underlines the encouraging cash flow profile of the oil explorer.

Tullow generates strong cash flow from existing discoveries. The company produces 100,000 barrels per day (bpd) of oil from its flagship Jubilee oil field in Ghana, west Africa. Tullow has a 35pc interest in Jubilee and this contributes the lion’s share of the full-year production guidance of between 79,000 and 85,000 bpd of oil.

Production looks set to be slightly down on the 84,200 bpd reported last year, which generated $1.9bn in cash for the company. However, Tullow added that building the infrastructure for the TEN project in Ghana is on target for production my mid-2016. Once completed this offshore oil field is expected to almost double production adding around 80,000 bpd of crude, a spokesperson for the company said.

Tullow is forecast to generate around $1.6bn in cash from the oil and gas this year after costs. The company is forecast to spend about $2.2bn on exploration and infrastructure during the same period which is split roughly half on exploration and half on developing existing assets. So, the debt levels are forecast to increase by about $600m, bringing net debt up to $2.8bn by the end of 2014. That compares to net assets on the balance sheet of $5.6bn and a market value of $7.8bn, so the debt looks manageable.

The company can afford to spend more than it makes from producing oil because it has financing in place. Tullow updated yesterday that it has $2.3bn remaining to use on its existing borrowing facilities. So, the company can continue to explore, develop new assets and pay out about $170m in dividends for the next two years at least.

There are certainly risks here. As with all oil producers if the benchmark price of Brent Crude were to fall below $100 then the numbers could begin to look strained. However, the price remains stuck above the $110 level for now. There are also risks that production could slip below target as happened with some UK-based assets during the first half.

Overall shares in Tullow look interesting. There is enough cash to fund the operation of existing assets and the development of proven oil fields. Analysts from broker Westhouse ascribe a value of $7.6bn or 524p per share for the oil fields already in production, of which Jubilee makes up around two thirds. Westhouse thinks that when the TEN field is successfully developed it could be worth about $1.7bn, or 127p per share.

There is also an exciting exploration programme in Kenya during the next 18 months that could provide a further boost to shares. Tullow has already discovered oil in this area at the Ngamia exploration well in Kenya’s Rift Basin. The company is drilling a further 13 new wells in the area, the majority of which come in the first half of 2015.

Questor thinks oil exploration in Africa is always high risk, but Tullow offers an interesting option as the risks are reduced by production from previous discoveries. The profits and earnings are lumpy given write-offs of assets but looking at the cash investors only have to pay about 8 times cashflow, Not for the faint-hearted this one but we upgrade to a buy.