The oil sector may seem rather akin to the ‘wild west’ at the present time, with the financial performance of its incumbents being heavily affected by a low oil price. As such, investors may be put off investing within the space, with it seemingly being difficult to assess just where the price of black gold and the profitability of oil companies will go over the short to medium term.
However, by focusing on valuations, profitability and margins of safety, it is possible to turn a low oil price to your advantage. And, while the ultimate performance of the oil price is beyond your control, through focusing on minimising risk and maximising potential return, you can begin to bring order to your exposure to a highly volatile, but very promising, sector.
For example, the likes of Tullow Oil (LSE: TWL) and Premier Oil (LSE: PMO) both offer exceptional value for money at the present time, which provides investors in the two companies with a relatively wide margin of safety. In other words, if the oil price does decline then both Tullow and Premier Oil could see their share prices hold up better than expected.
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In fact, despite recording mass-writedowns to its asset base last year so as to turn its bottom line from black to red, Premier Oil still trades at a substantial discount to its net asset value. It has a price to book (P/B) ratio of just 0.58 so that even if the value of its net assets falls by 42%, it would still be trading at a relatively appealing price. Similarly, Tullow has a P/B ratio of just 0.95, which indicates that the market is already pricing in a fall in its net asset base. If this does not occur, both companies could see their share price rise, while even if further asset write downs become a reality, their share price falls may not be so dramatic since investors appear to be pricing in such a scenario.
Meanwhile, the situation appears to be similar for oil explorer, Xcite Energy (LSE: XEL). It trades on a P/B ratio of just 0.45 but, unlike Premier Oil and Tullow, is expected to remain loss-making in each of the next two years. This is understandable, since Xcite is in a different phase of its development and, with it having an appealing asset base, it could prove to be a profitable long term investment.
However, with the current state of the oil industry and the huge uncertainty surrounding even some of the major players in this space, sticking with larger, more diversified stocks that are set to be profitable and which have more certain finances, seems to be a prudent move to make. Certainly, Premier Oil and Tullow Oil are more expensive than Xcite, but they also have more certain futures and could more easily cope with further challenges within the sector.
In other words, they appear to strike the right balance between being cheap and offering a stable near-term outlook. As a result, they seem to offer the more lucrative risk/reward ratio and could allow you to take advantage of the turbulence that is set to continue for oil explorers and producers.
