7 oil stocks with long-term recovery potential?

Disclosure: I have no financial interest in any company mentioned in this article.

This isn’t an article calling the bottom for the oil market — although I do expect this to happen at some point in 2016.

Instead, what I thought I’d do would be to suggest a few small and mid-cap oil stocks which appear to me to be well-positioned to ride out the storm and have attractive fundamentals for a long-term recovery.

This post was prompted by an article I wrote for the Motley Fool last week, in which I commented:

With oil now trading below $28 per barrel, I believe investors looking to invest in oil stocks need to ignore revenue and profit forecasts and focus on assets.

I’m looking for companies with cheap oil and gas reserves and enough cash to ride out the slump. I believe this approach has the potential to deliver big gains when oil prices do recover to more sustainable levels.

That’s the premise for this post. I’m looking for companies with three key qualities:

• Net cash and minimal debt
• Low valuations relative to their 2P (proven and probable) oil and gas reserves
• Low production costs

To help create a short list, I used Stockopedia (disclosure: I work as a freelance writer for Stockopedia) to screen for oil and gas companies with net cash, as this is non-negotiable for me*. With hedging benefits fading away and debt becoming scarce and expensive, any company that may need refinancing in the next 18 months is a non-starter, in my view.

*With one exception, see below!

Here’s the short list of UK-listed companies I came up with. This isn’t a complete list — I manually filtered it to remove obvious junk, micro caps and companies with no significant production:

• Amerisur Resources
• Cairn Energy
• Exillon Energy
• Faroe Petroleum
• Genel Energy
• Ophir Energy
• SOCO International

This is intended to be a fairly mechanical process. I’m not speculating about any of these firms’ future exploration/appraisal successes nor about their bid potential.

Based on share prices at 24 January 2016. I can’t guarantee the accuracy of these figures: they were compiled after a quick trawl through each company’s latest results/website to gather the relevant information. DYOR.

A few comments:

• Operating cost/boe are not comparable between companies as they are not all calculated the same way. I’ve relied on company provided data or made my own estimates, but the methodologies vary.
• Operating cost/boe is not an analog for cash flow breakeven (which is far more important). For example, SOCO says it can achieve operating cash flow breakeven with an oil price in the “low $20s”. Genel says it can breakeven with Brent at $20. Yet both companies have much lower production costs per barrel.
• Obviously some of these companies have specific political risks. For example Exillon (Russia) and Genel (Kurdistan/Iraq/ISIS). Funnily enough Exillon and Genel are the cheapest two in the list, based on a sum of operating cost/boe and EV/2P.
• Ophir’s valuation should probably also take into account its 900mmboe of 2C gas resources — but who knows when they will be commercialised or how much equity the firm will give away to fund their development? I suspect this could be a great long-term asset play, though.
• Cairn doesn’t yet have any production. We also do not really know what the operating costs for its North Sea developments will be when production does start in 2017.

Overall, it’s clear that even some oil companies with strong balance sheets and exceptionally low costs are currently valued very cheaply, relative to their 2P reserves.

I’d hazard a guess that at least some of the companies in the list above will deliver multi-bagging recoveries over the next 2-5 years. But I suspect one or two may not do, or will perhaps be forced to do heavily dilutive fundraisings.

Finally, I’d like to reiterate that these aren’t buy tips and I am not suggesting we’ve seen the bottom. I have no near-term plans to buy these stocks myself, although I do intend to monitor how they perform.

It’s worth remembing that even if we have seen the bottom for oil, it would be unwise to bet on a rapid recovery.  In my view, there’s a strong likelihood that prices will to stay below $50 for an extended time. Certainly I think it’s likely that companies which still have hedging protection, such as Faroe, will see theses hedges expire while oil remains well below $50. This is likely to have a very significant effect on cash flow.

Indeed, I suspect hedging expiries could trigger something of a shakeout among the more indebted North Sea operators, whose costs remain relatively high.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.