Pharos Energy

Pharos Energy (LSE:PHAR) has performed reasonably well over the past year. As markets have slumped, the firm’s share price has only fallen by about 6%. It currently trades at 23.1p. 

The firm, which is an oil and gas explorer and producer, has quickly revived its fortunes over the past two years.

In 2020, it reported a pre-tax loss of $241m. By the next year, this had turned into a pre-tax profit of $38.6m.

It’s no secret that most oil companies are currently benefiting from surging prices of both Brent and WTI crude oil. This price trend essentially makes Pharos Energy’s produce more valuable.

The company stated in November that it had seen high flow rates from the first three wells dug at its Vietnam operation, with a fourth well to be perforated in due course.

It has also drilled three wells at its project in Egypt, but recently agreed to sell 55% of its assets to a private equity firm. This transaction bags the company $5m immediately, plus significant performance-based add-ons.

Given the nature of oil exploration, however, it’s always possible that projects could deliver little or no oil.

Marston’s

Secondly, Marston’s (LSE:MARS) endured a torrid time during the two years of the pandemic. With restrictions on eating out, this pub firm really felt the pinch. It currently trades at 54p.

For the year ended October, between 2020 and 2021, however, pre-tax losses narrowed from £388m to £171m.

Furthermore, for the six months to 2 April, pre-tax losses were just £7.5m, down from £122m for the same period in 2021. Revenue also increased from £55.1m to £370m over the comparison period.

Although past performance is not necessarily indicative of future performance, these improving financial results do give me confidence as a potential investor.

While the business is now benefiting from the relaxation of pandemic restrictions, it’s also now feeling the effects of higher electricity prices, tighter food supplies, and wage inflation. 

The company does have certain pricing strategies up its sleeve to try and relieve this pressure, but there’s the very real chance that these economic factors begin to eat into future balance sheets.   

Overall, these two businesses are currently in decent shape. While their penny stock status does heighten my investment risk, I will be splitting my £1,000 equally and buying shares in both stocks next month.

A UK penny stock with potential

Oil & gas production and exploration company Pharos Energy (LSE: PHAR) released its full-year results report today.  The company has operations in Egypt, Vietnam and Israel. But 2020 wasn’t kind to the business because of the pandemic and the collapse of the oil price.

Revenue declined by just over 25% compared to the 2019 figure. And Pharos posted a big loss rather than profits because of a mammoth impairment charge “as a result of the oil price volatility and movements in 2P reserves.”

In years gone by, Pharos (then called Soco) used to generate loads of cash and pay generous shareholder dividends. However, net cash from operations plunged by 22% in 2020 and the company even raised just under £12m in a placing in January to fund phase 1B of its waterflood programme in Egypt.

Other measures to preserve cash include the directors taking a 50% remuneration cut from 1 April  — I hope they weren’t just fooling when they said that! And there’s no shareholder dividend.

However, we can’t blame the pandemic for everything. Pharos has struggled to maintain its profitability for some time. And the share price shrank from somewhere over 400p in August 2014 to just above 23p today. Perhaps one positive is the valuation looks undemanding by some measures. For example, the price-to-tangible book value runs near 0.6.

Operational progress

In the report, president and chief executive Ed Story pointed to some positives. For example, production was in line with previous guidance. And the company received an extension to its TGT and CNV licences in Vietnam. In the third quarter of 2021, Pharos plans to start drilling in accordance with its TGT Full Field Development Plan. And that plan secured final approval during 2020.

Story said the operations in Vietnam have the lowest breakeven in the firm’s portfolio. And that means investments there have a quick payback time. On top of that, the drilling programme will be fully self-funded from the operating cash flows generated in the country. And the company expects to achieve post-capex free cash flow in the first half of 2022.

In Egypt, Story reckons reserves have been “significantly” upgraded. And the waterflood programme has begun.  Meanwhile, Pharos is “well advanced” in its search for the “right” farm-out partner to invest in the project.

When a UK penny stock has been performing as poorly as Pharos has for so long, it takes a leap of faith to embrace the forward-looking operational potential. But I reckon the outlook’s positive and the shares may be worth holding now.

However, today’s stock price around 23p is well up from the lows last autumn near 10p. And the business operates in a cyclical industry with much of the trading outcome dependant on oil prices, which is outside the directors’ control.

These shares come with many risks, but I’m tempted to tuck a few away for the long-term recovery and growth potential of the underlying business.

Mr Slater was right. But for most of us, who have limited time to research and manage our investments, I think it makes sense to hold a mixture of reliable elephants and smaller, more exciting stocks.

An elephant I’d buy

BP (LSE: BP) is a good example of the kind of elephant I like to own. The shares are unlikely to double. But in recent years, the company has shown how investors can benefit from investing in elephants.

The huge financial impact of the 2010 Deepwater Horizon disaster was followed by the 2015/16 oil market crash, which saw oil prices drop below $30 per barrel at one point. Despite these pressures, BP only missed three quarterly dividends in 2010 and didn’t cut its payment at all in 2015/16.

Today, the company has restructured its operations to be profitable at lower oil prices and is starting to focus on debt reduction.

Analysts expect BP to report underlying earnings of $0.53 per share for 2019 and pay a dividend of $0.40 per share. Although earnings cover for the dividend looks fairly slim, cash generation has improved over the last couple of years. I expect this payout to remain safe.

These forecasts price BP shares on 12 times forecast earnings, with a dividend yield of 6.4%. I rate this FTSE 100 giant highly as an income buy. But I don’t expect too much in the way of growth. For that, I think we need to look elsewhere.

This small-cap yields 9%

The next company I’m going to look at is SOCO International (LSE: SIA). This £250m oil and gas producer operates in the waters off the coast of Vietnam and at onshore oil fields in Egypt.

At the time of writing, SOCO shares offer a dividend yield of 9%. Such a high yield normally means that the shares are too cheap, or that a dividend cut is likely.

Personally, I think this stock could turn out to be a serious bargain at current levels. Group production is expected to reach about 13,000 barrels per day by the end of 2019. Production costs are low, at less than $10 per barrel. Historically, this has enabled the group to generate very high levels of free cash flow.

Using this week’s half-year accounts, my sums suggest that SOCO shares trade on just six times underlying free cash flow from the last 12 months. If this level of cash generation can be maintained, then I think the dividend should be safe. The payout might even rise.

At a last-seen price of 65p, these shares also trade at a 37% discount to the firm’s net tangible asset value of 103p per share.

This looks like a bargain. What’s the catch?

The main problem seems to be that growth has been limited in recent years and CEO Ed Story’s strategy is unclear. Is the business, which Mr Story founded, heading for a long-term decline?

A strategy day is being planned for City analysts in October. Hopefully we’ll find out more then. Until that time, I continue to feel that SOCO is a potential bargain for small cap investors.

One reason for this is that oil prices have fallen sharply over the same period. But oil price aside, are there any other factors shareholders should be aware of? And are Premier shares still cheap?

I’ve been taking a closer look and will give my verdict below. I’ll also consider the investment case for another oil stock that looks cheap to me but offers limited visibility for shareholders.

Good progress

A trading update in May suggests that PMO boss Tony Durrant is continuing to deliver on his operational and financial targets.

Mr Durrant has increased production guidance for the year from 75k to 75k-80k barrels of oil equivalent per day (boepd). He also advised investors that if oil prices stayed the same, debt reduction would be at the top end of the firm’s $250m-$350m target for the year.

It was a solid update that didn’t raise any red flags for me.

Are the shares still cheap?

As I’ve written before, Premier shareholders need to remember that the firm’s valuation is still dominated by its enormous debt pile.

Net debt fell from $2.33bn to $2.25bn (about £1.75bn) during the first four months of 2018. But that still dwarfs the market value of the firm’s shares, which is about £685m.

What this means is that when valuing these shares, we need to look at the firm’s enterprise value (market cap + net debt) to get the full picture.

At the time of writing, Premier’s enterprise value was about £2.5bn. That’s about 7.5 times last year’s free cash flow, which looks pretty affordable. The equivalent figure for Tullow Oil is about 11, for Royal Dutch Shell it’s around 12. However, both of these larger companies pay dividends and benefit from stronger balance sheets than Premier.

In my view, Premier shares are probably fairly valued at current levels. As debt continues to fall I’d expect the shares to make further gains. But the share price will remain very sensitive to changes in the oil price, so shareholders may need to be prepared for a lively ride.

A true bargain?

One oil stock that’s failed to benefit from strong market conditions is Asia-focused SOCO International (LSE: SIA). This former favourite has continued to drift lower over the last year and now trades at just 66p. That’s a 33% discount to the stock’s net asset value, which I estimate at 99p per share.

Why is SOCO so cheap? Unlike Premier and Tullow, it has net cash and a track record of generous dividends — the stock currently has a forecast yield of 6.8%. Another plus is that founder and CEO Ed Story still has a 3.5% shareholding, suggesting his interests should be well aligned with those of shareholders.

I think one reason why this stock keeps drifting lower is that the market isn’t sure where this business is going. Its Vietnam assets remain cheap to run and cash generative. But we don’t yet have much information about the performance of Merlon, a recent acquisition in Egypt.

In my view, SOCO carries some risk. However, the company’s historical performance and its focus on cash generation suggest to me that the shares should probably be worth more. I’d rate the stock as a contrarian buy.

The firm’s shares have fallen by about 65% since June, after flow testing the Icewine #2 well failed to produce any oil. 

The company is actively searching for a ‘farm-out’ partner to share the costs of continuing to drill and evaluate the Icewine acreage. The deadline for bids was the end of 2018, but in an update today the firm said this had been extended into the New Year.

Multiple “high-quality” companies are said to be examining the Icewine data while considering a bid. But the falling price of oil probably isn’t helping. A deal is now being targeted during the first quarter of 2019, so that there’s still enough time to schedule “the drilling of multiple wells” during the 2020 summer season.

A big worry

As a pure explorer, 88 Energy doesn’t have any oil or gas production or any other source of revenue. This means it relies on cash from shareholders and loans to fund its operations.

Unfortunately, investors are becoming less willing to supply fresh cash. In October, an attempt to raise A$14.33m (£7.96m) from existing shareholders only yielded A$3.6m.

In November, the firm tried again, hoping to raise £5.9m from by selling new shares to investors through brokers. This raised £5.56m before costs — more successful, but still short of the firm’s target.

My verdict

88 Energy does have a large and prospective acreage. The firm could still make a big, valuable oil discovery. But this is very much a gamble, in my view.

Financing seems to be getting harder to find and interest costs mounting on the group’s loans. This stock is much too speculative for me.

I’d buy this instead

Although I do invest in small oil companies, I have a rule of only investing in firms which have commercial reserves and ongoing production. What I look for are companies that can fund their exploration activities entirely from their own oil and gas sales.

This may seem dull and boring, but it helps protect me from the kinds of losses often suffered by shareholders in speculative stocks such as 88 Energy.

One of my top picks in the small-cap oil sector at the moment is SOCO International (LSE: SIA), which is one of the largest producers in Vietnam. This company is still run by founder Ed Storey, who has a 4.2% shareholding in the firm.

A bid target?

Mr Storey is now in his 70s. I wouldn’t be surprised if he looked for a takeover bid or a merger at some point in the next few years, to allow him to step back from the business.

In the meantime, SOCO is expanding its operations into Egypt via the acquisition of Merlon. This deal should add at least 6,500 barrels of oil per day to the group’s production and generate strong free cash flow, thanks operating costs of just $6 per barrel.

Analysts expect SOCO’s earnings to take a step up next year, doubling to $0.14 per share. This puts the stock on a 2019 forecast price/earnings ratio of just 6.3. This looks good value to me, especially as it’s paired with a dividend yield of nearly 7%.

That’s good news for shareholders. But over the long term, rising profits don’t always translate into market-beating shareholder returns.

You see, oil companies annual profits are driven by operating costs per barrel in their reporting. But the cost of developing oil and gas projects is sometimes greater than the cost of operating them. Only by adding development costs and operating costs together can you understand the full-cycle cost.

This all-inclusive measure gives us a longer-term view on profitability. We can use it to estimate whether a company is generating real wealth for shareholders, or whether it simply recycles profits into new projects without any residual gains.

An easy alternative

Companies don’t always provide their full-cycle costs. But you can get an idea of how profitable a firm’s investments have been using a standard accounting metric called return on capital employed, or ROCE. This compares operating profit to the capital invested in a business.

To show you what I mean, I’ve calculated the six-year average ROCE for four oil companies:

Why I like Soco

Vietnam-focused Soco has paid generous dividends for a number of years, while maintaining a net cash balance. It’s no surprise to me that it ranks highly for ROCE.

Perhaps by chance, Soco also recently published the full-cycle costs of an asset it’s planning to acquire. Merlon’s El Fayum asset in Egypt’s Western Desert has operating costs of just $6 per barrel, but a full-cycle break-even cost of $34 per barrel.

Both numbers look attractive to me, but what’s so interesting is the difference between them. Perhaps this focus on full-cycle costs is why Soco has historically generated a higher ROCE than many of its peers.

After recent falls, it is one of the top shares on my oil market buy list.

What about the others?

Shell has already reduced net debt by more than $10bn from its 2016 peak. Alongside this, it’s maintained a generous dividend and started buying back shares. There’s clear evidence here of strong cash generation, even if some of it has come from disposals.

By contrast, BP has maintained its dividend but only at the cost of rising debt. Overall returns have been low. At the bottom of the pile, Premier Oil has been forced into a massive refinancing and paid no dividends. Given this, you might ask why I own shares of Premier.

Management and assets

The answer is that I rate Premier’s operational management quite highly, and I believe the company has good quality assets.

Timing has been poor in recent years, but I think management should be able to deliver on expectations to cut debt and double profits in 2019. If I’m right, then the stock’s 2019 forecast P/E of 4.3 should leave room for considerable gains from current levels.

However, I won’t keep the shares for the long term unless I see evidence that return on capital employed is rising to attractive levels — which I would view as 10%-15% while oil prices remain high.

Out of Africa

The international oil and gas exploration company’s stock peaked at 448p in February 2014, but it has been downhill ever since. Today it trades at just 87p and has a market cap of £297m, but the worst may now be over.

Soco is selling off its final African interests as part of a process of portfolio rationalisation, banking $10m from assets in Brazzaville, Congo, and another $5m from interests in Cabinda, Angola. Its main operations are now in Vietnam, but today it announced its acquisition of the Merlon Petroleum El Fayum Company for $215m, a privately owned oil company with an onshore concession in Egypt.

Into Egypt

This should help the group diversify its resource base and expand both in Egypt and the wider Middle East and North Africa. President and CEO Ed Story has a good tale to tell in today’s six-month interims, with a first-half focus “on execution of our strategy of portfolio rationalisation and finding new growth projects, whilst returning cash to shareholders”.

It reported a strong balance sheet, with a cash and liquid investments balance of $128.8m and no debt, and low cash operating costs of just under $14 a barrel against an average realised crude price of $74.08 (up from $53.90 last year). 

The future does look brighter, with forecast 11% earnings per share (EPS) growth in 2019, and a current yield of 6.3%. This is a shrinking concern and in 2013 revenues topped $608m against a forecast $165m for 2019, but it now has a more solid platform for the future. Peter Stephens calls it risky but potentially rewarding, and that sounds about right.

Tullow to go

FTSE 250 share Tullow Oil (LSE: TLW) has also had it tough, its share price peaking at $1,333 in 2012 then plunging to just $242 today. Recent times have been kinder, though, with the stock up 45% in the last year.

Tullow is exploring again after several years of retrenchment when its stretched balance sheet restricted operations. It now aims to ramp up production from current assets in West Africa, progress two large onshore developments in East Africa, and step up the search for new fields in Africa and South America.

Free cash flows

The £3.38bn group recently turned a $557.9m first-half loss into a $150.5m profit, helped by the stronger oil price and a small increase in production. My Foolish colleague Roland Head reckons it offers seriously good value at today’s price. 

Tullow also reported a free cash flow of $401m, which has doubled in a year, and can now make serious inroads into its net debt pile, which fell from $3.8bn to $3bn by 30 June. With its massive Ghanaian field producing tens of thousands of barrels a day, the cash should keep flowing.

Trading at a forecast 11.6 times earnings, Tullow does not look overpriced. Both oil stocks have weathered the worst, although Tullow looks the safer bet.

Could this mean that after a period of strong gains for the company’s shares, it now offers an impressive risk/reward ratio. Or is there a better option within the wider oil and gas industry at the present time?

Bright future?

As mentioned, there is scope for 88 Energy’s placing to reach AS$17m. This will be undertaken via a proposal to raise A$12m, plus the ability to take over-subscriptions of up to A$5m. The money raised is to be used to fund the continued evaluation of conventional and unconventional oil targets on Alaska’s North Slope. Even though the company has a cash balance of over A$10m, it has a major work programme ahead which may require additional funding.

The shares in the company will be priced at an 11% discount to its average share price in the last month. That means they will be A$0.037 each, and this appears to have contributed to the company’s significant stock price fall following the news.

Clearly, 88 Energy is a relatively high-risk stock which lacks the size and scale of a number of its sector peers. But after an improved period for the wider oil and gas industry, it could offer high returns over the long run. It appears to have a solid strategy, although it is highly dependent upon the quality of news released regarding its exploration and development programme.

Therefore, while it may only be of interest to less risk-averse investors, it could have a favourable risk/reward ratio for the long term.

Improving prospects?

Also offering upside potential within the oil and gas industry at the present time is Soco International (LSE: SIA). The company has experienced a challenging period, with asset writedowns hurting its financial performance, while it continues to trade on an exceptionally high valuation. It is due to move into profitability in the current year, but with a price-to-earnings (P/E) ratio of 75 it seems as though investors may already have factored this in.

Still, Soco International has no debt and appears to have the potential to generate improving cash flow. This could help to support a dividend which yields over 4% at the present time and could move higher if the company’s performance improves. Given the prospects for the oil price, there is a good chance that both profitability and investor sentiment across the sector could improve, and this may boost the company’s stock price.

And with the potential for M&A activity in future, as well as a relatively efficient business model, the prospects for the business appear to be risky but potentially rewarding. As such, it may be of interest to less risk-averse investors.

Unlike some, Soco is generating cash and paying dividends — the 5.25p per share for 2017 was ahead of forecasts and provides a yield of 5.4% on the current 98p share price.

The firm did record a big loss of $157.3m, including a $152.3m write-off of exploration and evaluation (E&E) assets, although excluding those E&E assets gives an underlying loss of $5m. That’s not a big loss, but it’s close to the restated $6.4m loss from last year and it comes after a year of rising oil prices.

What do I like?

But the company stressed its “strong and robust balance sheet, zero debt, solid cash flow, and low cash operating costs.” Operating expenditure, while up slightly on last year, amounted to $13.73 per barrel and it ended the year with cash and equivalents of $137.7m. 

Based on my colleague Roland Head’s evaluation of Soco’s asset value, the shares look to be trading at a discount to NAV of around 26% and I find that tempting. But what’s likely to out the hidden value that I see in Soco?

The abandonment of the firm’s mooted merger with Kuwait Energy was, I think, a disappointment, as it could have produced a combined entity with nicely diversified assets. Something along those lines could still happen as Soco said it “continues to pursue growth opportunities of scale, which meet our investment criteria.”

No profit

Frontera Resources (LSE: FRR) is more typical of a startup oil explorer, still in its cash-burn phase and with no forecast profits on the horizon. But with the oil price having recovered strongly over the past 12 months and now pushing at $70 per barrel, we’re arguably in much better times for such enterprises. And exploration progress has been going well.

At Frontera’s T-45 well at the Taribani Complex in Georgia, drilling has uncovered 98.9m of combined pay interval in three targeted zones, with an additional 14.9m combined pay interval at a fourth zone. The firm “observed a number of oil and gas shows during drilling operation.” Wireline and pressure pumping companies are now set to move in.

In the last week, drilling operations have commenced at the next well in the complex, Dino-2, with a depth of 2,700m expected to be reached during April — aimed at three of the same targets as T-45.

Well stimulation

The latest update from the company on Thursday announced that pressure pumping equipment, intended for well stimulation operations at T-45, will start its journey from Romania in the next few days.

Fundraising in February raised $4m through two equity issues and Frontera appears fully funded for exploration at its three main targets. 

With no revenue or profits, it’s hard to put a valuation on the shares. But if a well-funded oily with promising assets is what floats your boat, Frontera looks like a good candidate — especially if you expect, as I do, oil prices will recover further in 2018.

Shares rise on merger fail

On paper, the proposed merger between Vietnam-focused oil and gas producer SOCO International (LSE: SIA) and Middle Eastern group Kuwait Energy had some logic. The combined firm would have had much higher production, substantial reserves and a geographically diverse portfolio.

However, the two companies couldn’t agree on terms and issued statements today confirming that the deal won’t go ahead.

SOCO shares rose by 2% in early trading as investors welcomed the clarity provided by this announcement. This stock has fallen by about 40% over the last year, even as the oil market recovered. I believe this could be a buying opportunity.

Too cheap to ignore?

SOCO’s most recent accounts show net cash of $132m and a book value per share of about 180p per share. However, I calculate that the company’s January decision to writedown the value of two non-core assets in Africa by $220m will have reduced this to about 133p per share.

At a last-seen price of 94p, it means the shares currently trade at a discount of around 29% to my estimated book value.

Supporting this value is the group’s strong cash flow. With operating costs averaging just $14 per barrel, today’s oil price of more than $60 should leave plenty of cash for development work and dividends.

Shareholders are expected to receive a total payout of 5.3p per share for 2017, giving a yield of 5.6%. A smaller payout is expected in 2018, but SOCO does have a long history of returning cash to shareholders. I believe the stock could be good value at current levels.

Will shareholders strike gold?

Russia-focused gold mining group Petropavlovsk (LSE: POG) has had a turbulent history. Its shares have lost 98% of their value since 2010 and the firm only just survived in 2015, when a big rights issue was required to help refinance $1bn of debt.

Shareholders have grown tired of the firm’s limited progress and the last year has seen the enforced departure of company chairman and founder Peter Hambro and his long-time ally, CEO Dr Pavel Maslovskiy.

A turning point?

Debt has remained stubbornly high and the group’s decision to invest in a so-called POX Hub — a specialist plant needed to extract gold from some types of ore — isn’t without risk.

However, progress is being made. Most remaining debt has now been refinanced on a more sustainable basis. Operationally, the new management team is overseeing a significant improvement in profit and cash generation.

The stock currently trades at a 43% discount to its net asset value of 12.8p per share, and on just 6.6 times 2018 forecast earnings.

If management can successfully release value from the group’s mines and operate the POX hub profitably, then I’d expect the shares to re-rate, perhaps towards the 10p-12p range. This isn’t without risk. But Petropavlovsk shares do appear to offer value at current levels.