Financial Analysis of Tullow Oil - Case Study Example

Introduction Tullow Oil is one of the largest oil and gas exploration and production companies in Europe with major operations in UK, South Asia and Africa. According to the information available on company’s website1, Tullow has over 100 licenses in more than 23 countries with major operational activity in Africa, Europe, South Asia and South America. The recent corporate moves of the company include the $595 million acquisition of the Hardman Resources Limited which provided company an easy and substantial access into markets like Uganda and Mauritania besides offering high impact exploration licenses in South America. Head Quartered in London, Tullow employees more than 250 people all over the world with production capacity of approximately 80000 barrels per day. In 2007 company was drilling more than 40 wells spread across the globe. The overall global strategy of Tullow has always remained in the domain of making long term investments in assets and markets where company’s skills and expertise can make a difference. Besides investing in long term assets, Tullow follow a consistent strategy of following growth. Tullow’s focus has always remained on the exploration and exploitation of its existing resource base with more operational innovation and active portfolio management. It is because of this strategy that company is focusing on acquiring assets and making acquisitions in order to create synergy and achieve value for its stakeholders. Company is also continuously focusing on making capital expenditures and reinvesting the major portion of its profits into the business in order to fund growth of the business through its own internal resources. Share’s Beta Using Slope function of MS Excel, the Beta for the Stock is Beta= -0.49 Excel formula = Slope (Known Y axis, Known X axis) The beta is negative because of the fact that stock returns and market returns almost run parallel in opposite directions. The tullow stock has continuously risen in price whereas FTSE over the period of 52 weeks has shown a negative return. Risk and Return Risk is measured using standard deviation of the stock prices over the period of 52 weeks therefore using MS Excel, the standard deviation of the Tullow’s stock prices is Standard Deviation of Tullow Stock = 110.743 Return2 The price appreciation over the period of 52 weeks in the stocks of Tullow, by using MS Excel, comes to =75.15% There is a negative correlation of -0.21 between the stock and the market. Comparison UK Gilts are considered as the most secure securities as they are backed up by the government of UK. In every market, all government securities issued are considered as risk free investments and returns offered by them are almost considered as risk free rate of investment. Therefore to make a direct comparison between risks free investment security and a security open to most of the risks in the market in a direct way will be little bit difficult to make. It is because of the fact that all other securities other than offered by the government are virtually open to every risk under the sky however government securities are, to some extent, shielded from certain risks. It is because of this, the government securities offer lower rates than the rates offered by the other securities. There is also a fact that Gilt securities are government BONDS and are fixed income securities. They technically zero coupon bonds offered at discount and pay face value at the maturity whereas stocks do not have any maturity and they don’t offer fixed returns in case of common shares. It is because of this that a direct relationship or comparison can not be made. However by evaluating the risk return profile of Tullow’s stock, we can safely assume that Tullow’s stock is more volatile than that of Gilt and offers much higher returns than the Gilt is offering in the market. Risk & Return of a Portfolio Return of a portfolio is a weighted average return of all the stocks present in our portfolio. In our case there are three shares in our portfolio therefore the return will be the weighted average rate of return of the three stocks. In the absence of any pre-defined weights, we are assuming to allocate equal weightage to the all stocks present in the portfolio. Based on that assumption, the return of the portfolio, using MS Excel is: Weighted Average Portfolio Return = 3.15% Risk of a Portfolio Portfolio risk is a different consideration and is not a linear function as portfolio returns are. It is therefore considered that Portfolio risk is difficult to comprehend especially when the number of stocks in the portfolio increases. The basic tenets of the Risk Management suggest that it is not wise to look into the risk and return profile of just one stock bur rather investors should invest into multiple stocks so that a degree of diversification is achieved and risk is minimized. (McClure). Based on the information the risk of the portfolio is = 36.814 Weakness of the Model The model which has been used to evaluate the risk and return profile of this stock is Capital Asset pricing Model or CAPM. Theoretically, CAPM model works under certain special conditions. The first condition outlined under this model suggest that the individuals are risk averse in nature therefore they will maximize their end period wealth. It is because of these theoretical limitations, the CAPM model is often termed as One Period model. The second very critical weakness of this model is the fact that CAPM outlines that all the investors have uniform information and thus every information is available to the investors which often not the case. This assumption is especially in contrast to the Efficient Market Hypothesis Theory which clearly indicates the degrees of information available and the market’s cumulative response to it. There is also growing evidence which suggest that the equilibrium prices under perfect market conditions do not reward diversification. (Khan) It is therefore largely argued that the non-inclusion of diversification in the pricing of the assets effectively nullify the impacts which diversification can have on the risk profile of the asset. Analysis The oil market in current scenario is on boom. Oil has shown tremendous increase in price in recent past and the recent reports suggesting the oil prices crossing 100 USD per barrel mark. Globally industry is booming which is also evident from the stock performance of the Tullow over the period under review where it has consistently being able to beat the market in price appreciation. This increasing trend in the price of the stock strongly suggest that the confidence of the investors in Tullow and its future growth prospects. However one also need to consider the fact that Tullow is in exploration business and not in the direct marketing and distribution of gasoline and its exploration sites are mainly located in Africa and UK where the cost may be one of the critical factors for the Tullow to handle in the future. Secondly, these regions are not considered as the major oil producing nations therefore their output levels hardly move the market sentiments in their favor and there is hardly any bargaining power left to Tullow like it is with OPEC therefore Tullow may find itself in difficulties as for as the long term sustainability of its oil is concerned. There are also very strong Political risks involved in this industry too. With Iraq already under the threat by extremism and strong anti-western sentiments, a slight weakening of the allies’ government in this region can seriously hamper the whole industry. As we are already witnessing the increasing prices and emergence of new and alternative energy technologies, the long term future of the exploration industry specially in the oil and gas sector may not be as bright as it used to be because the alternative sources will not only be cheap but preferred too because of their environmental friendly orientation. The notion of green fuel and especially bio fuel will be the next competitors of oil in future as Ethanol is in current scenario which is taking the lead in the international market. The emergence of Ethanol seems also to force Tullow to divert its focus more on the sugar cane producing countries which are again the developing countries, therefore if Tullow start to make strategic decisions earlier, it may have to change its whole business perspective to a newer level because Ethanol, unfortunately can not be explored and once the international standards and political pressures allow greater mixing of Ethanol with the oil, the traditional market of the oil and exploration may decline due to an automatic decrease in the demand for the oil as the higher contents of Ethanol will be mixed with the oil. Advice By looking at the current scenario, I would suggest a buy and hold strategy in the short term investment horizon whereas for long term investment horizon, considering the volatility of the stock, I would suggest a sell action from the serious investors with no immediate liquidity issues. References Khan, M.A.Ali. "The capital-asset-pricing model and arbitrage pricing." Economic Science (1997). McClure, Ben. "Modern Portfolio Theory: An Overview." 2008. 6 March 2008 . Read More