The recent oil price slump has left many big oil stocks looking cheap, especially if you expect the oil price to bounce back.
That seems to be the view held by management at Tullow Oil (LSE: TLW). The FTSE 250 oil producer has announced plans to restart dividend payments in 2019. The firm also hopes to develop “two major projects in Uganda and Kenya that have the potential to grow the Group’s production by 50%”.
This bullish stance is only possible now that the firm’s debt levels have fallen to more reasonable levels. But this strategy also suggests that Tullow boss Paul McDade expects oil prices to stabilise at levels that will support profitable growth.
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How cheap is the stock?
At face value, Tullow stock looks quite cheap to me. The shares trade on a 2018 forecast price/earnings ratio of 8.7, falling to a 2019 P/E of 7.
Free cash flow excluding a one-off gain is expected to be $500m this year, giving a forecast price/free cash flow ratio of just 6.7.
This influx of cash will help to reduce net debt, which is expected to fall to $2.8bn by the year-end. This will give a leverage multiple of 1.8x EBITDA (earnings before interest, tax, depreciation and amortisation). That’s comfortably below my preferred maximum of 2x.
The right time for growth?
Mr McDade says that “having embedded cost discipline across the group”, now is the right time to focus on growth. I agree that the time is probably right and share his view that Tullow has some attractive assets to develop.
My concern is that the company hasn’t shown great financial discipline in the past. Tullow went into the 2014 oil price crash with far too much debt. The firm ended up having to raise cash from shareholders in a rights issue, and hasn’t paid a dividend since 2014.
Although the business is now generating plenty of cash, the shares are still worth about 85% less than at their 1,300p+ peak in 2012. Will Mr McDade manage to create lasting value and income for shareholders, or will this be another boom and bust story?
Tullow stock could do well from here, but for long-term investors I think there’s a better option elsewhere.
Sustainable long-term growth
Companies providing technical services to oil exploration and production companies have struggled to return to profit growth since 2016. But if Tullow’s view on growth is shared by other companies in this sector, then demand for oil services could start to grow.
One of my preferred stocks in this sector is John Wood Group (LSE: WG). The group’s 2017 acquisition of Amec Foster Wheeler has left it positioned to expand into other industrial sectors, but oil field services remain a core part of the business.
Unlike Tullow, I believe Wood Group does have a good track record of financial discipline. The group’s dividend has been held or increased each year since 2004, and shareholders have never seen the kind of value destruction endured by Tullow investors since 2012.
Wood Group stock currently trades on 14 times 2018 forecast earnings, with a 4.2% dividend yield. Analysts expect earnings to rise by 24% in 2019, giving a P/E ratio of 11.4. I rate the shares as a buy.
