Being an investor in oil stocks has been a bruising experience in recent months. Looking ahead, most investors expect more pain and the prospect of further declines in the price of oil simply can't be ruled out. That's because there continues to be a supply glut that's showing little sign of ending while demand for oil seems unlikely to rise in the short run, due in part to a slowing Chinese economy.
Against this backdrop, it takes a lot of courage to buy shares in oil companies. Certainly, there are huge risks involved in doing so at the present time, with paper losses being a realistic obstacle for buyers of oil stocks. However, there could be significant rewards in the long run for those investors who are brave enough to go against the market and buy now.
One oil stock that has substantial upside potential is Tullow Oil(LSE: TLW). As the company's update from this week stated, it's on track to increase production over the course of 2016 and beyond via its Project TEN in Ghana. In fact, the project is now 85% complete and is expected to produce its first oil between July and August of this year.
The impact on the company's profitability from Project TEN is set to be significant, with it due to help Tullow reach earnings per share (EPS) of 10p in the current year. This puts Tullow on a forward price-to-earnings (P/E) ratio of around 14.5, which indicates relatively good value given the prospect of further rises in profitability over the medium term.
Of course, Tullow isn't without risk. As its results showed, its revenues fell by 27% in 2015 and when impairments and writeoffs are taken into account, it led to an after-tax loss of $1bn. However, with operating cash flow standing at $1bn and a cash balance of $1.9bn, Tullow appears to be well-equipped to grow its production and this could lead to rising profitability and improved investor sentiment over the medium-to-long term.
Also enduring a challenging period is Premier Oil(LSE: PMO). Like Tullow, it has been forced to write down the value of its assets, but unlike many of its peers, Premier Oil is seeking to take advantage of the current weakness in oil prices to improve its asset base. It's doing so through the purchase of E.ON's North Sea assets for $120m and this has the potential to improve Premier Oil's profitability in the medium-to-long term.
With Premier Oil being forecast to return to profitability in 2016, it currently trades on a forward P/E ratio of just 7.7. This indicates that there's significant upside potential and while there's the prospect of further writedowns if the price of oil does remain low, the company's risk/reward ratio continues to hold appeal for less risk-averse investors.
As with Tullow, the prospect for short-term pressure on Premier Oil's share price remains high. But in the long run, the potential to benefit from a strengthening of the company's position relative to its peers, plus its low valuation, mean that it could prove to be a sound buy in the coming years.
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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended Tullow Oil. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.