Oil surged through the $50 barrier last night, as production disruptions provided fresh support for the price of black gold.
Global production is thought to have fallen by more than a million barrels a day, due to supply disruptions in Canada, Nigeria and Libya. Output from US shale producers is also dropping. The latest US government figures show that crude production has fallen from 9.56m barrels per day a year ago to just 8.77m barrels per day last week.
In my opinion, this is the real deal -- the oil market is starting to rebalance. So is now a good time to invest in oil producers?
Shareholders could still face losses
Tullow Oil (LSE: TLW) reported net debt of $4.5bn at the end of April. That's an increase of $500m in the first four months of the year. Although the firm should be funded through to the completion of its TEN project, I worry that shareholders are underestimating the challenge of repaying this debt.
Tullow is expected to report after-tax profits in 2017 of just $203m. This won't make much of an impression on net debt, which could be close to $5bn by then. Plans to cut capital expenditure from $1bn to $0.3bn in 2017 should stop debt rising, but I'm not sure it will be enough to generate free cash flow to repay debt.
It's a similar story at Premier Oil (LSE: PMO), where net debt has ballooned to $2.2bn as the firm has continued spending on its Catcher and Solan projects in the North Sea. Solan is now starting to produce revenue, while Catcher is on schedule for next year.
Operationally, the firm is doing well, but I'm concerned by Premier's recent admission that it's renegotiating its banking covenants for the second time in two years. This suggests to me that the company sees some risk of breaching these covenants in the near future.
Although Tullow and Premier have good quality assets, I suspect that both firms' lenders will require them to focus on debt reduction as cash starts to flow from new production. I fear that this could leave very little cash for shareholder returns, or for pursuing attractive new projects.
I don't believe, for example, that Premier is going to develop the Sea Lion field in the Falkland Islands anytime soon.
That's why I'm more interested in investing in oil companies with strong balance sheets and the ability to generate real profits for shareholders.
Cash + a big discovery
One potential example is Cairn Energy (LSE: CNE), which has a 40% stake in the Sangomar field in offshore Senegal. This is shaping up to be one of the biggest discoveries by a UK operator in recent years. Cairn also has cash of $502m and an unused $575m lending facility.
Drilling results so far have enabled Cairn to upgrade its 2C contingent resource assessment to 385m barrels. The latest drilling results from the SNE-4 well, which found a 100m column of oil, suggests that further upgrades are possible.
While Cairn has little in the way of current production, the firm's North Sea interests are expected to start producing revenue next year. I believe Cairn could be a safer and more profitable investment than Tullow or Premier Oil at current prices.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.