With any investment, the risk/reward ratio has to be favourable in order to take the plunge and buy. If the risks outweigh the potential rewards then it’s always a good idea to sit back and wait for either a keener share price or a better opportunity elsewhere. With the resources industry being relatively risky at the present time, it’s clear that the possible reward on offer must be significant in order to tempt any investors to spend their hard-earned cash on a slice of an incumbent business.
While some resources companies fulfil that criteria, others don’t. Although they may prove to be excellent long-term investments, the timing may not be quite right at the moment. For example, northern Iraq/Kurdistan-focused oil producer Gulf Keystone Petroleum (LSE: GKP) has a superb asset base, with low cost of operations and has the potential to deliver excellent levels of profitability in the coming years.
However, Gulf Keystone’s location is a major risk for investors, since it operates within a region where political uncertainty is high. Undoubtedly, the company has done a stellar job of maintaining its production levels amidst difficult trading conditions, but the current valuation doesn’t appear to be sufficiently enticing to warrant purchase at the present time. And with Gulf Keystone also having a huge number of debtors, its price-to-book value (P/B) ratio of 0.6 continues to lack appeal.
Wait and see
Similarly, Cairn Energy (LSE: CNE) also has excellent long-term potential, with its drilling programme in Senegal yielding positive results so far. Furthermore, it remains fully-funded from existing resources and expects to take its North Sea developments through to free cash flow generation by 2017.
However, Cairn Energy is forecast to post a pre-tax loss of £180m in 2015 and a pre-tax loss of £82m in 2016. While this is to be expected for a company that’s still focused on exploration rather than production, investors are becoming increasingly nervous regarding the prospects for oil after its slump to around $30 per barrel. As such, it seems likely that investor sentiment towards profitable businesses will remain stronger than towards those that are using up cash. Therefore, due to a nervous market, Cairn Energy may be a stock to watch rather than buy at the present time.
Meanwhile, shares in oil and gas company IGAS (LSE: IGAS) have fallen by 10% already this year. It has come under scrutiny from the market due to it having a net debt position of £64m and widening losses that increased from £3.8m in the first half of last year to £19.3m in the current year.
Of course, writedowns and impairments contributed significantly to this increase in losses. But with investors already being nervous regarding the prospects for oil and gas companies, it may be prudent to invest in stocks that have a more stable financial footing. That’s despite IGAS having a P/B ratio of just 0.4, although with the price of oil having the potential to fall further, additional asset writedowns can’t be ruled out.