Investing in oil companies has been a rather challenging pursuit in recent years. After all, the price of oil slumped to below $30 per barrel in early 2016 before mounting a comeback that has seen it double in the intervening period. Clearly, this has caused problems for oil producers, but results from one growth play show it’s gradually overcoming the challenge of lower oil prices. In fact, its shares could rise by over 40% in the next two years.
A changing business
Tullow Oil (LSE: TLW) has previously been known as a relatively high-risk oil exploration stock. However, today’s results for 2016 show it’s now transitioning towards being a lower-risk oil producer. Certainly, exploration will remain a key part of its future, but capital expenditure is expected to fall by $400m to around $500m in the current year. This shows the business may now be more focused on production than in developing new assets.
On the topic of production, Tullow’s delivery of Project TEN in 2016 is set to transform the business. It will vastly increase its production capacity and has already made the company free-cash-flow-positive in the final quarter of the year. The aim is for Tullow to gradually cut its sizeable debt pile, which should reduce its overall risk profile and could lead to more investor interest.
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Growth potential
As with any oil company, Tullow’s forecasts depend on the price of oil. The prospects for black gold appear to be positive, since demand is expected to gradually catch supply in the next few months. This should support a higher oil price and could mean the company’s forecasts are upgraded.
However, even if they’re not, there appears to be at least 40% upside on offer between now and 2019. Earnings are due to move from negative in 2016 to positive in 2017, followed by growth of 75% in 2018. While it could be argued a degree of this improving financial performance has been priced-in by the market, a price-to-earnings growth (PEG) ratio of 0.2 indicates there’s still some way to go on the valuation front. If Tullow was to rise by 40% and hit its forecasts, it would have a price-to-earnings (P/E) ratio of 18.9 at the end of 2018. Given its upbeat long-term outlook, this could still be cheap.
Outlook
As mentioned, the outlook for oil could be positive and it may prove to be a sound place to invest. Valuations across the sector remain suppressed, with Nostrum (LSE: NOG) trading on a PEG ratio of just 0.1 at the present time. Like Tullow, it’s forecast to move from loss to profit in 2017, but Nostrum is due to post a rise in its bottom line of 175% in 2018. This indicates its shares may outperform those of its sector peer, especially if oil prices remain robust.
While both stocks are relatively risky, their wide margins of safety indicate that now is an obvious time to buy them. Their share prices may remain highly volatile, but over the next couple of years, the rewards for investors could be significant.
