After Tullow Oil Rights Issue, will the shares recover?

The recent Rights Issue of $750m from Tullow Oil is to ease liquidity, as its debt approaches $5bn. The question is: “Will it be enough and at a time when the oil price starts to recover?   

Tullow Oil shares have been struggling for years, whereas companies like Shell and BP saw limited downside.

The oil price did recover by 40% to 50% from its lows in January 2016. Causing some minor oilers shot up by 80-200%.

Tullow Oil PLC recovers by 40% from its lows.

Still, the destruction of shareholder value was too strong and the impact affects longer-term shareholders of Tullow Oil.  

 

For instance, if you are a loyal (L-T) shareholder (for 10 years), you have made no money (See Below, for the scary chart):

Tullow Oil weekly chart

Given that the oil price fell by 55%, the collapse in Tullow’s share price to (£1.28/share, at its trough) from £16/share is a fall of 93%!

So, why has Tullow Oil dropped further than the oil price?

A few factors come to mind: –

-Overleveraged;

-Cost of production is higher makes it sensitive to the oil price;

-The share price was overvalued at £16/share causing a steeper decline;

– And, operational issues. 

 

On the flip side, others would ask: “Is this the RIGHT time to invest in Tullow Oil?”

If you are an oil price recovery believer, this makes for a good story.

Assuming it does, then with some operational improvements (i.e. debt reduction). You can expect Tullow’s share price to appreciate at a greater percentage than the oil price.

It’s like a leveraged play, where you use leverage to increase your returns.

Here is a simple example of leverage by investing in a more volatile oil producer:

If Tullow’s shares recover back to its previous highs of £16/share from the current £2.29/share. You will make a 600% return!

But, does the oil price needed to jump by 600%?  Unlikely, because that means the oil price would trade around $320/barrel!!!

 

Issues covered in this Post

Before reading any further, here are the following issues covered on Tullow:

  1. Change in Market Value;
  2. The effect of LOWER oil price on sales generation;
  3. Has lower oil price affected its cash generation?
  4. Explaining and calculating Tullow’s Rights Issue;
  5. Why debt borrowings caused the shares to fall first?
  6. Cost of production per barrel, including capital expenditure;
  7. The total capital expenditure in the last ten years. Is the money well spent?
  8. A look at its 2017’s profit guidance and comparing actual 2016’s results with its previous guidance to test reliability;
  9. The factors affecting the oil price;  

Now, we go into details of these findings. 

 

Lower Oil Price reduces Tullow Oil Business Value

Earlier, we mentioned that long-term shareholders made no money in the past ten years. But, people should be aware of Tullow Oil’s market value. If the company starts issuing “confetti” it dilutes the share price, while maintaining market valuation.

Below are two graphs showing the market value and enterprise value.

tullow oil market value

The market value did dip below 2006’s level, however, the increase in debt makes the oil producer more financially leveraged.

Now, let’s look at the numbers.

With debt, Tullow Oil’s enterprise value is 120% higher today, than in 2006.

It also explains why the market value went as low as it did. Because without further financing and improvement from external oil markets. Tullow would struggle to make money to pay off its liabilities.

 

Low Oil Price reduces the Assets ability to generate sales

 Tullow Oil sales generative assets

One interesting way of looking at sales turnover is: “How much was Tullow able to generate in sales for every GBP (British Pound) it holds in Assets?” 

It has declined from 25 pence to 10 pence of sales output for every £ of assets, then four years ago, also lower than 2008/09 levels.

The cause or curse of this deterioration is the prolong low oil price.

 

As an oil producer, Tullow needs a lot of “upfront capital” to develop its fields before making a dime. That means investors or lenders need to make upfront payments to Tullow’s projects, before seeing a return on investment.

As Tullow been producing oil for some time, we can assess the capital turnover.  

Looking at the chart, Sales is generating less than 20 pence for every British Pound invested (that is Debt, plus Equity minus cash). In 2011, it was around 40 pence.

 

Conclusion: We don’t know what the right level of capital turnover and sales turnover should be because every oil producers have: –

  1. Different cost structure (i.e. depths of oil & gas fields, the amount of oil, royalties paid to various interest groups and etc.);
  2. At different stages in the business cycle;
  3. Have different E&P and A&D ratios;
  4. Value assets differently;
  5. And, different quality of oil assets.

But, we do know that high oil prices mean better economics for all oil producers.

 

Lower oil price helps to reduce Tullow Oil to generate operating cash from assets

If sales generation per unit of assets fell, then the same thing occurred with operating profits and net profits.

A better measure is to use net cash earnings generation from assets. (See cash generation chart below)

 Tullow Oil cash cover

The operational impact of Tullow Oil on its “Net Cash Generation” is below 5% of its assets value in 2016. It used to generate 12% to 17% of cash earnings from its assets. Looking at the raw numbers, net cash earnings were £417m in 2016, down from the peak of £1.1bn in 2011.

A fall of 60%. With the shares, currently down by 82% from the peak.

P.S. It went as low as £1.30/share, a fall of 93%.

There is a case the shares, undershoot to the downside.

However,

 

Tullow Oil shareholders got to face up to its new reality. And that is the share price won’t return to their previous highs.

Here are two reasons why: –

One, the recent Rights Issue means more shares outstanding, causing share price DILUTION.

And, two, the level of net debt on the oil producer balance sheet has doubled from 2011.   

Unless the oil price goes above $150/barrel, it is hard to phantom how Tullow will regain £15 to £16 per share!

P.S. The “$150/barrel” was a guess, and to illustrate the point of what dilution does to the share price!  

 

Let’s us look at this in more details.  

 

Reason one: Tullow’s Rights Issue

The Rights Issue offer for Tullow’s shareholders is 25 for 49 rights issue, at 130p per share (A 35% discount, I believe). The issue aims to raise circa £600m ($750m).

The new shares would increase total shares outstanding from 914m to 1.38bn, giving it a market capitalisation of £3.16bn, as well as approx. 466m new shares.

What if you took up your Rights?

For example, you are a long-term Tullow’s shareholder having bought 10,000 shares at £8.32/share, the total value of £83,200. (Ignoring transaction fees)

With the shares at £2.29, you are sitting on a loss of approx. £60k. Still, you are willing to help Tullow Oil out by participating in the Rights Issue.

How much more do you need to fork out?

 

Doing the maths.

25 FOR 49 Rights issue means you get to subscribe for a further 25 new shares for every 49 shares held.

Take 10,000 shares and divide by 49, then multiply by 25.

(10,000 ÷ 49 = 204, then 204 x 25 = 5,102 shares)

At £1.30/share, you pay £6,632.

 

Round-up

Your original shareholding would have gone from 10,000 shares to 15,102 shares.

 

Selling today

Since these are nil rights, you can sell after purchase. The price depends on the market price of Tullow Oil.

Tullow’s share price was £2.29/share (as of 13/04/2017, and some days after the Rights) and you decide to sell your Rights shares.

You would make a £0.99/share profit. (£2.29/share minus £1.30/share)

Or, £0.99 multiple by 5,102 shares = £5,051 or 76% of profit.

 

Drawback from selling your Rights after purchase

From the above example, the quick £5k profit means that individual would still nurse £55k in losses.

The ultimate question these Rights participants would ask: “Is this enough to elevate the company’s liquidity constraints?

If the oil price recovers, then this is good news for shareholders who will see their losses pare back.

It would be the best outcome.

If oil prices fall further, this will weaken Tullow Oil operations causing the shares to decline. Then, speculations arise on a further Rights Issue can’t be ruled out.

 

(For further examples and explanations of Tullow Oil Rights Issue, click HERE.)

 

Reason Two: Tullow Oil Debt Intake

Tullow was ramping up the development of its oil fields at a time when the oil price was collapsing. Since 2013, Capex spending totals over £5bn.

So, how did they fund their projects?

First, look at Tullow’s net cash earnings, that totals £3.3bn in the last three years, which is a shortfall of £2bn.

If oil price stayed around $80-$90, it would internally fund these projects.

Instead, it got funded through borrowings.

Below is the total debt levels with rising financing costs.

Tullow oil debt levels

Tullow’s total debt did fall back from £2bn (2011) to less than £1bn, two years later.

As mentioned, it needs to fund future projects. And that caused Tullow to take on £4bn worth of debt.   

Furthermore, Tullow net interest costs rose from £30m in 2013 to £140m.

 

Debt increase started the share price decline

The oil price collapse was part of the reason why Tullow’s shares fell. But there is proof that too much debt intake was equally to blame (if not more) for Tullow underperformance.  

Here are two distinctive charts to prove that hypothesis:

Tullow’s share price between January 2012 and May 2014

Tullow oil share price between 2012 and 2014

That was when the oil price was $75 and higher.

WTI Oil price between mid-2012 to late 2014

By the time, WTI oil price chart started to collapse in the summer of 2014, Tullow Oil share price was trading around £6 and £7 per share.

Most of the share price decline was down to poor financial performance (i.e. operating profits were £245m in 2013 from £700m+ from the previous year). And the continued of large capex spending.

 

Tullow Oil’s oil production and reserves

As Tullow is an oil producer, you must assess oil-related metrics. Apart from looking at the net reserves and resources attributed to the group and daily production output.

These are the other meaningful indicators: sales volume of oil, revenue per barrel and operating cash flow per barrel.

By working out the annual oil barrels sold, you can estimate the time for Tullow to run down its reserves.

Below is the working interest production, sales volume and reserves and resources for the last ten years:  

Next is Tullow’s sales in oil barrel terms:

Tullow oil revenue per barrel

 

This is similar to the change in oil price, but you must remember that Tullow hedge a large portion of oil at future prices.

It is why 2015’s revenue per barrel of $67 is higher than the $52 bucks recorded for that year. 

In the past 10 years, Tullow Oil produced a total of £7.3bn in net cash earnings, while incurring net investing activities (including disposals and acquisitions) of £9.6bn.

The problem: – Capex and acquisitions aren’t covered by operating cash earnings and disposals.

Although, this investment has doubled net reserves and resources from 507m barrels to 1,193m barrels.

Also, the sales volume saw an increase of 2,600 bopd from 2006’s levels, a 5% increase.

Investors should question Tullow’s management.

At the end of the day, do you, as a shareholder of Tullow feel it is worth spending almost ten billion pounds just to increase oil production of 5%?

 

Before people start pointing out that oil is finite and oilers need to find a replacement to its depleting reserves. The total volume of oil sold that is attributed to Tullow is 243m barrels since 2006.

Doing some simple maths.

Oil reserves & resources increase: 1,193m minus 507m = 686m.

Add in the oil sold in the last ten years: 686m + 243m = 929m.

Capital spent per barrel to finding this replacement: £9.6bn ($14bn) divided by 929m = $15 per barrel.

Note, the numbers may look low because it excludes the operational costs of extracting this oil. Also, this is an average capex over a ten-year period. On a year-to-year basis, it is more volatile.

 

To know more about its operational costs, read the section titled “The Situation at Tullow

 

The Situation at Tullow

What is the future of Tullow’s business?

With the oil price hovering around $50/barrel plus because of OPEC cutting oil production. There are some geopolitical uncertainties. These have been ongoing for a few years with little impact on the oil price.

One reason why it remains subdue is the rise of U.S. oil production that are offsetting Mid-East political tensions. Then, there was the slowdown in the Chinese economy affecting other emerging economies such as Turkey and Brazil.

But, now there is a new adversity, the diplomatic and political tensions in North Korea. That is because Japan, Korea and China are net oil importers. If a crisis were to occur, expect these Asian economies and the “trickle-down effect” to other emerging and developed economies resulting in the use of less oil demand.

 

At the moment, nobody knows where oil is heading.

It is prudent to stick with the situation at Tullow Oil. 

 

 

Sticking with Tullow’s future operations, these are the things to take away from its January’s trading statements: –

  1. Oil production guidance in Africa and Europe is between 84,000 and 92,000 bopd for 2017, up from 71,700 bopd in 2016.
  2. Capex is forecast at $500m, down from $900m.
  3. Here is Tullow oil hedge position:
HEDGING POSITION (as at 31 Dec 2016)

 

201720182019
Oil Volume (bopd)42,50022,0007,979
Average floor price protected ($/bbl)60.2351.8845.53
Gas Volume (mmscfd)3.67
Average floor price protected (p/therm)40.47

 

What do you make from this guidance?

An increase in oil production could lower the costs of production, this could increase operating cash earnings.

The lower capex is welcome (after years of heavy spending), and it could produce positive free cash flow.

And the hedging position? At least, Tullow secure 42,500 bopd at an oil price of $60/barrel, which is above the current $52.

Does it mean Tullow Oil will produce a better performance than in 2017?  

The only way to find out is by reading past trading statement such as the 2016’s January trading statement!!!

 

How reliable is Tullow Oil guidance?

First, the oil production guidance for 2016 was between 78,000 and 87,000 bopd. The actual oil production average 71,700 bopd.

Why the big miss?

One big reason is down to its Jubilee field in Ghana. Something to do with the turret getting damaged. That contribute around 26,000 bopd to Tullow Oil (around 35% of total oil production).

Some would argue this was a “one-off” and the situation is under control.

However, not long after this guidance (the 2017’s trading statement), the company reduces oil output by over 5,000 barrels per day! And guess where the oil reduction is coming from?

The Jubilee field in Ghana!!

Rule: Like Benjamin Graham say, “Always have a margin of safety.”

Oil production doesn’t always go to plan. So, you need to stay prudent and not get excited by increased production announcements.

 

 

Next, is Tullow’s oil hedge positions, which reveals some interesting details. Here is the table from the previous year:

HEDGING POSITION (as at 31 Dec 2015)

 

201620172018
Oil Volume (bopd)36,51123,0009,500
Average floor price protected ($/bbl)75.1572.9462.09
Gas Volume (mmscfd)0.61
Average floor price protected (p/therm)63.00

 

Essentially, Tullow Oil has hedge half its oil production at $75/barrel, which helped them to earn an operating profit of £94m. Adversely, net cash earnings still fell by 50% to £417m.

This doesn’t look promising because of this:

 

Tullow Oil’s Cost of operations

 Tullow Oil Costs of operations IN USD

The reduction in costs has improved to $51/barrel from $60/barrel. But, here is the bad news.

Tullow oil hedge of 42,500 bopd at $60/barrel, this is 20% lower than last year hedge price! With current oil price fetching $51/barrel, then the average price per barrel of oil sold estimated at $55/barrel.

However, this estimate is subjective to a number of assumptions including: –

  1. Changes to oil prices;
  2. Operational disruptions;
  3. Political instabilities.

 

Also, the operational costs didn’t include new capital spending. As 2016’s capex is at $838m, higher than the $380m reported for depreciation and amortisation (which is included in the calculations).

That extra $458m of capital costs gets added to $1,095m (total operating costs, see graph above). So, $1,553m/21.6m = $71.9 per barrel. That is above the current oil price

 

Is Tullow, a Recovery Play?

I don’t know and no one does.

It is best to list two sets of factors for people to evaluate from. One should be bullish and other bearish.

 

Bullish list

-If oil price stays at current levels or moves higher, it will benefit Tullow Oil exponentially.

-One reason investors are optimistic is the reduction of capex to $500m this year, down from $900m last year.

-Higher oil production guidance of 84,000 bopd to 92,000 bopd is at least 12,300 bopd above last year production numbers.

Higher output means more barrels sold, which would lower operating costs per barrel.

-OPEC cutting oil production, supporting the oil price.

 

Bearish List

-If instead, the oil price averages below $50 per barrel showing no sign of any recovery.

It is a bad sign because, by 2018, Tullow will effectively sell oil on the market at the market price. That will put pressure on Tullow’s margins, as the Rights Issue money gets used up.

-Operational disruption causing management to cut guidance;

-U.S. ramp up production would dampen any rise in oil price;

-North Korean crisis turn into a full-scale war would weaken oil demand from South Korea, Japan and China.

In times of war, commerce and trade deals take a back seat.  

-The current £3bn valuation and 1.38bn shares outstanding would cap share price appreciation.

-Global stock market valuation close to record highs, a pullback would likely drag most stocks lower.

 

 

Whether you believe in the bullish or bearish lists, you got to be realistic with reasonable reasoning. 

At the end of the day, this is important:

Before the Rights, Tullow market valuation was £1.8bn at £2/share. Now, it raised $750m, reducing net debt to $4bn.

If operations deteriorate, and Tullow used up all the Rights “financing”, expect the shares to drop to £1.20/share or lower.

Because a second “Rights” or more borrowings will follow!

Call to Action

Sorry for the long-ass piece on Tullow. What do you think about this oil producer? Are there factors affecting this company I have neglected to mention?

Then please drop your knowledge and ideas below in the comments section.

Don’t forget to share on Facebook, Twitter and Linkedin. Subscribe if you enjoy this post.  

 

Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.

 

Further Reading/Other views

  1. Fat ProphetsTullow Oil” This is old article advising investors to buy the shares because the stock has fallen by 50%.
  2. Master InvestorThis factor could hold the key to Tullow Oil’s future” by Robert Stephens CFA.
  3. Seeking AlphaShould You Participate in Tullow Oil’s Cash Call? A Review” by The Investment Doctor.

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  • Andrew Boag

    Hi

    Nice analysis – they have indeed wasted capital but you have to see it within the total cycle in my opinion. They could not have foreseen a drop in prices – or if they could that is not their remit as extractors of oil.

    This stock was severely overpriced at the top and today looks under priced to me – it acts like an option post rights issue as if they can run the stock for Cash to keep the creditors happy it will still be around for the next rise in oil prices.
    I wrote a piece on the rights issue and did profitably (short term anyway) take up my rights…
    http://theamiableminotaur.blogspot.com.au/2017/03/tullow-oil-tlw-when-your-long-term.html

    In the end TLW is a trade – it is THE trade for UK investors on oil prices – BP and Shell have lots of upstream insulation. Companies like Horizon and PMO are a lot smaller with less financial flexibility – TLW is therefore the midcap oil trade and hence the massive volatility – note when oil rose $5-7 in the rights period the share price briefly went above the price before the rights issue despite trading ex-rights!

    Not short-mid term great- but an interesting long term option on oil prices.

  • Thanks for the feedback Andrew.
    I think most oil producers have capital commitments that are 2, 3 or 4 years into the future. They do their best to hedge oil prices at optimal as possible.
    On the Rights Issue, what can I say. It all depends on your perception of where the oil price will trade in the future.

    There is one thing I have missed and that is most oil producers are cutting back on capex for this year and next, which would help boost aid oil price in the future.