The defeat of Tap Oil?
Recommendation
The battered oil price continues its relentless downward spiral, this week falling to just over US$30 a barrel, the lowest close in 12 years. In the US, the cause of the supply glut, inventories are at 80 year highs. Before prices recover, oil production needs to fall substantially and oil inventories must be drawn down. Lower prices have sparked higher consumption but there is still an awful lot of oil about.
For producers, this means an extended downturn is likely. For diversified businesses, those with strong balance sheets or low costs, this will mean pain in the short or medium term. For others, however, the price plunge is an existential crises. Tap Oil is arguably in this category.
With revenue dwindling and debts to repay, Tap is raising money but it is doing so by issuing fresh equity at 30% of book value. This is disappointing for Tap and its investors. There are few glaring management errors and the business has a history of conservative capital allocation. We don't, however, recommend pouring more cash in. Although its shares are statistically cheap, the downside from here is greater than the upside.
Key Points
Low oil prices hurting
Raising cash to preserve covenants
Upside limited by hedging
The price is wrong
The Manora project was sanctioned in a price environment of US$100 a barrel. Even if prices halved, the project would still deliver free cash flow and debt would still be repaid. No one, ourselves most of all, expected the carnage we are now seeing. With prices at US$30 a barrel, oil producers are bleeding and Manora will struggle to generate a return.
Tap, which had for years held a large net cash balance, had to take on debt to finance the Manora field. That was the right choice. Today, however, net debt stands at US$36m, a sum that is greater than the equity value of the business and enough to threaten the company.
A Macquarie-brokered finance deal has been withdrawn and an existing facility with another consortium will need to be repaid using drastically lower revenues. The terms of that loan also require the business to maintain US$10m in liquidity.
Tap has hedged part of its production at slightly higher prices and the capital raising helps to meet liquidity hurdles. The hedging has avoided disaster for now but the company is obliged to hedge on a rolling basis and will soon be forced to lock in extraordinarily low prices.
A dim view
The one bright spot for investors is the presence of acquisitive Asian oil business Risco, which owns 19.95% of Tap. Northern Gulf Petroleum, another major shareholder which also owns about 20% of the business, has proved to be a distraction rather than a white knight.
In the best case scenario, Risco will move to take over Tap. In the absence of a takeover, however, the upside is small. Tap is forced by its bankers to hedge at low prices and lock in today's lousy returns. Even if it survives, the business wont boom from an oil price recovery. Payoffs for investors are, therefore, asymmetrical and the downside is greater than the gain.
We noted in our last update that the investment case for Tap was broken (see Tap's broken thesis). We should have sold then. Expectations of higher prices and the prospect of a takeover stayed our hand but we wont repeat the mistake again. We do expect oil prices to recover over time and there will be attractive ways to gain in that event. This isn't one of them. SELL.