After checking in on Fresnillo (OTCPK:FNLPF), a London-listed silver and gold producer, we are staying on the British island for this week’s edition of Focus on Europe. And, although we remain in the commodity sector, this week’s focus will be on another segment as Tullow Oil (OTCPK:TUWLF) (OTCPK:TUWOY) is focusing on its oil production in Africa. Now, the Brent oil price continues to trade above $70/barrel, Tullow is basically printing money, and even after its recent 30% share price increase, the company remains cheap. Is it the Africa Discount? Or is there something else going on?
Did you miss the previous Focus on Europe article? You can re-read it here!
What a great year for Tullow Oil
I have been a bit quiet on Tullow Oil after discussing the company’s cash call in 2017, but I still have a soft spot for this African oil and gas producer.
In Tullow Oil’s case, the low oil price, combined with the high net debt, was hurting the company, but my main argument was focusing on the serious reduction in the capex level over the next few years, which should automatically result in a much higher free cash flow and a lower net debt. I expected the debt problem to correct itself.
In 2018, Tullow Oil produced on average 81,400 barrels of oil equivalent per day and sold roughly 90% of that amount, equalling 74,200 boe/day. The average received price was $68.50/barrel (thanks to an excellent Brent oil price), and this resulted in Tullow Oil’s full-year revenue of $1.86B.
Source: financial results Tullow Oil
The low-cost nature of the production wells was once again confirmed as the gross profit generated on that revenue exceeded the $1B mark, as it came in in excess of 30% higher than the FY 2017 result. This wasn’t just due to the higher oil price as the total revenue increased by $136M, while the gross profit increased by $267M.
As you can see on the next image, Tullow Oil was once again able to reduce the production cost per barrel of oil from around $12 to just $10. In 2019 it does expect to see some additional cost savings, but let’s not get ahead of ourselves as a production cost of 10 dollars per barrel is absolutely excellent. Tullow now expects its break-even oil price to be $40/barrel (and this includes production expenses, royalties, etc.).
Source: company presentation
As there was no impairment charge like the $539M in FY 2017, and despite writing off $295M on exploration (versus just $143M in FY 2017), the operating profit increased by a factor of almost 20 to $528M, and even the bottom line shows a positive result with a net income of $84.8M, or 6.1 dollar cent per share.
Not bad at all. But rather than paper profits, what Tullow Oil really needs to reduce its net debt is hard dollars.
The cash flow statement shows an operating cash flow of $1.2B, but this underestimates the taxes by $72M, the $235M in finance expenses (mainly the interest expenses, I am not taking FX changes or changes in the value of derivatives into account here). And, also includes a $19M contribution from working capital changes while it ignores a $2.9M interest income.
After taking all these adjustments into consideration, the adjusted operating cash flow was roughly $881M, of which approximately half ($440M) was spent on capital expenditures. Most of these capex dollars were made towards further growth, and the sustaining capex very likely is just a fraction of that amount. Also, keep in mind Tullow Oil had already expensed almost $300M in exploration, so the company has been very aggressive on the exploration front.
Even at the current lower oil price, Tullow Oil should still be able to generate in excess of $400M in free cash flow (although this will also depend on how much additional higher risk exploration will be expensed as well), so the $100M minimum dividend shouldn’t be an issue at all, especially now the Brent oil price is holding up very nicely.
Now, Tullow sees the cash flowing in at in excess of $2M per day, it’s no longer afraid to spend it. It has been guiding for a capex hike to $570M in 2019 on the back of more than doubling its capitalized exploration efforts (it’s unclear if this will go hand in hand with a reduction in expensed exploration expenditures, so it doesn’t necessarily mean the total spending will increase considering the amount of expensed + capitalized exploration in FY 2018 totalled $357M).
Source: company presentation
On the production side, Tullow Oil will see the immediate benefit of increasing its production rate in Ghana, as the company is now aiming to produce 100,000 boe/day throughout the next few years. This 25% production hike should have a meaningful impact on the operating cash flow as well, considering the additional oil will come from low-cost production wells, similar to the current offshore Ghana operations. Ghana remains incredibly important for Tullow Oil, and the company is planning to drill an additional seven wells, which should also help to increase the resources and reserves, and to upgrade some resources into reserves.
While Ghana remains an important cornerstone of Tullow Oil’s strategy, future production growth will still come from the East African assets (Kenya, Uganda), as Tullow Oil considers these oil fields to be an integral part of its plans to boost the production rate to 150,000 barrels of oil-equivalent per day. Tullow is now targeting the Final Investment Decisions to be sanctioned in 2019 (but let’s be cautious and take some additional delays into consideration).
Source: company presentation
Once those FIDs will have been taken, the Guyana discoveries will very likely be prioritized. Tullow is planning a 3-well program in 2019, perhaps followed by an additional two well program in 2020. In fact, Tullow does an excellent job showing what its exploration priorities are, and what the concrete plans are:
Source: company presentation
The net debt has now decreased to just over $3B (I was expecting it to be a bit lower, but a $200M claim related to a breach of contract issue decided otherwise. Excluding this payment, the net debt would have been just $2.85B), and with an EBITDAX (the EBITDA excluding expensed exploration efforts) of $1.6B, the debt ratio has fallen below 2.
Considering Tullow Oil plans to increase its oil production to 100,000 boe/day and despite the slightly lower oil price, I think we can once again expect a similar EBITDAX, but perhaps another $200-300M decrease of the net debt, which would further reduce the debt ratio to 1.6-1.7. I do think Tullow Oil should perhaps be a bit more aggressive in its efforts to lower the net debt as reducing it by a few hundred million per year is adorable but doesn’t really move the needle much on a $3B net debt situation. Rather than cashing in a $100M dividend on a yearly basis, I strongly feel that money should be used to pay off debt. After all, Tullow effectively paid roughly $235M on $3.22B of gross debt, the cost of debt is approximately 7%.
So, paying off as much debt as possible will have a noticeable impact on the free cash flow as well as repaying $400M per year would save the company $28M per year in interest expenses and boost the after-tax free cash flow by $22M. That’s 17M GBP, or approximately 1.2 pence per share per year. Negligible? Maybe. But I prefer the money to end up on Tullow’s bank account rather than paying it to its banks.
Tullow Oil remains a strong operator, and the acute debt issues appear to have been solved now.
Other news from Europe
A few weeks ago, Norsk Hydro (OTCQX:NHYDY) (OTCQX:NHYKF) had to confess its IT systems were hacked, and the company has now almost reached its normalized production levels again. It’s remarkable how a cyber-attack has an impact that’s still noticeable three weeks later, but fortunately, its Q2 results shouldn’t be hit too hard.
Cyber attacks are tough, but it’s even tougher when your own staff steals your IP. Dutch chipmaker ASML (ASML) (OTCPK:ASMLF) now mentioned it had to deal with corporate theft a few years ago. Market commentators quickly pointed fingers at China, but ASML downplayed this rumor and didn’t want to provide more details.
German car makers remain in the center of attention, even several years after Dieselgate. BMW (OTCPK:BMWYY) (OTCPK:BAMXF) (OTCPK:BYMOF) will very likely include a 1B EUR provision in its next set of financials as a provision for the accusation the brand was colluding with Volkswagen (OTCPK:VWAGY) (OTCPK:VLKAF) (OTC:VLKPF) and Daimler (OTC:DAIMF) (OTCPK:DDAIF) (OTCPK:DMLRY) to hide the actual emission levels of some of its models. Cheating seems to be the norm in Europe these days as the European Commission also fined General Electric (GE) last week for not telling the whole truth when the conglomerate acquired a Danish supplier of wind turbine parts.
Sports Direct (OTCPK:SDISY) (OTCPK:SDIPF) owner Mike Ashley failed to acquire the department store chain Debenhams (OTC:DBHSF) (OTCPK:DBHSY) which subsequently filed for bankruptcy. Rather than securing ownership in an attempt to merge Debenhams with other stores Ashley already owns, his investment in the company is now being wiped out, along with all other shareholders.
Talking about shareholders being wiped out, Belgium’s Nyrstar (OTC:NYRSF) (OTCPK:NYRSY) is still halted as it needs to update the market on its recapitalisation plan. It’s doubtful the existing shareholders will be made whole. They may not be wiped out entirely, but it looks like main shareholder and creditor Trafigura will make a move to secure ownership of Nyrstar’s crown jewels and is willing to go far to accomplish that. And, to be honest, it has every right to do so. Right before the trading halt, Nyrstar’s share price increased by approximately 30%, so that’s either shorts covering their bets, or a genuine belief the existing shareholders won’t be wiped out
UK bank Standard Chartered (OTCPK:SCBFF) (OTC:SCBFY) has agreed to pay roughly $1.1B to settle the lawsuits in the UK and USA which accused the company of violating the US sanctions against Iran. An expensive lesson for Standard Chartered as the settlement represents approximately half its expected net income for this year. About $950M will be paid to the US authorities, while the UK regulator will receive 102M GBP as part of this settlement. Standard Chartered isn’t the only bank in the EU that had to deal with the regulators; Italy’s UniCredit (OTCPK:UNCFF) (OTCPK:UNCRY) received an enquiry of the European Commission as the regulating body thinks the Italian bank violated the competition rules.
And, finally, Banco Santander (SAN) is making an offer to acquire its already majority-owned Santander Mexico (OTCPK:BMEXF) division. This should allow it to streamline operations, but Santander doesn’t intend to delist the Santander Mexico stock from the exchanges should it not be able to gain full control.
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Disclosure: I am/we are long TUWLF, NYRSF, SAN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.