Friday, 24 March 2017

Tullow Oil (TLW): When your long term holding becomes a bit more long term

So aside from my position in Diamond Offshore (NYSE:DO) I also have the pleasure of owning quite a few shares in Tullow Oil (LON:TLW). It is funny as just two weeks ago I was thinking 'I really need to revisit Tullow Oil and their leverage ratios as they might do a capital raising.' I didnt get around to it and then 'oops' they just announced a $750m cash call with heavy dilution. 

TLW is not exactly a classic 'value' stock - it is more of a special situations investment.

I have been a buyer of TLW since early 2015 and just like with DO I was too early to the cycle and it has gone on longer than expected. My first entry prices were around the 400p - 350p per share mark. The stock bottomed in January 2016 at around 130p per share (fortunately I traded some here for a very tidy gain by March 2016). It has seemed to be on the path to recovery trending up with oil prices over 2016. Until now. The prolonged depression in prices has made TLW a slave to its huge debt load so the company announced a rights issue to bring back financial flexibility.

So the main question is; should I subscribe, sell, buy more? 

The first consideration is the oil cycle. I was clearly too early into TLW thinking it looked good value if the drop in oil was a blip - but it wasnt - so much like DO I have been sticking it out through the bad times. I expect in the next few years the cycle will turn as the chronic underinvestment of 2014-2017 starts to lead to a supply crunch and kicks off a new cycle of investment.

The second consideration is; will TLW still be here when the next cycle starts its virtuous path? I think yes, certainly after this cash call. I estimate that with the~ $735m in net rights proceeds alongside FCF generation of ~$400m net debt should reduce to $3.6bn by end of 2017. This would bring 2017E net debt/EBITDAX down from 5.2x to 3.2x. This should bring the net debt levels back below the required 3.5x of the covenants which was breached previously. If FCF generation is Nil for the year then debt sits at the 3.5x limit. I would imagine the company and their bankers thought about this metric ahead of the rights issue.

FCF generation should be driven higher in 2017 by operating cash flow due to rising production from TEN with total production +24% at 88.6k boe (including Jubilee field insurance) and higher oil prices on average against 2016. (Note that around half the 2017 production is hedged with a floor at $60.23bbl.) This combined with a huge cut in capex following the completion of TEN from $0.9bn to $0.5bn should drive up FCF and enable TLW to pay down debt.

How to play the cycle? TLW has a very interesting market position as a play on higher oil prices - unlike some of the minors (Premier, Rockhopper, GKP) TLW has the ability to raise equity (albeit at a steep discount) because they have the size and clout of a FTSE 100 company (at least for now). But interestingly TLW also stands to benefit by orders of magnitude from high oil prices due principally to its financial leverage and operating leverage as a pure play E&P. This also explains why TLW has hugely underperformed the majors; Shell and BP over the period since 2014. They have the balance sheets to whether the downturn and the upstream assets to fall back on.

Google Finance

TLW shares are unlikely to gain in value in the near term without an improvement in the earnings department. Earnings have been depressed due to heavy impairments of assets and capitalised exploration expenditure. TLW will always have a reasonable level of written off exploration due to the nature of the business but in 2014-2016 the company has written off and written down a total of $4.8bn in capitalised assets and expenses, hence the losses. Impairments peaked in 2014 and with a much leaner business losses have narrowed into 2016 and EBITDAX margins have actually improved to the highest level since 2013. 

Margins including EBITDA ex impairments/write offs

Now clearly impairments are a real cost they just aren't a present cash cost (representing past cash outflow) - therefore what we can see here is that underlying profitability has improved. 

SG&A driven by Impairments - note the 2014 spike

This is due to a well executed cost cutting plan and focus on core low cost production principally finalising the TEN oil field. Operating cash costs per barrel are competitive and have been falling; these assets are cheaper than US shale for instance which is currently the swing producer.

TLW Annual Report

So much like DO the story of TLW is a story of leveraging up to increase capacity at exactly the wrong time - but back in 2013 nobody foresaw the precipitous drop in the oil price. With that leverage now on its way down and underlying profitability improving TLW should survive to play the waiting game on higher oil prices.

A rights issue usually has the medium term impact of drawing a line under poor share price performance and given the magnitude and high dilution of this issue it seems that management have 'kitchen sinked' it. No management wants to have to do a second cash call so they tend to overestimate the requirements for the first one.

Based on this analysis I most likely will subscribe for the rights and buy my allotted shares. I have sold some TLW since the announcement at a significant loss with a view to buying them back in my tax free ISA account should the price drop much below the 200p TERP in the interim.

The long term remains the long term oil outlook and it appears likely now TLW will be around to see it following this capital raising.

Disclosure: I have an established modest long position in LON:TLW. This is not a solicitation and does not constitute advice for investors considering the TLW corporate action. These are opinions only, not investment advice. If in doubt read my disclaimer.

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