Can this stock survive an oil price slump?

Updated: 
Shell

Oil and gas company Nostrum(LSE:NOG) has released an operational update for the nine months to 30 September. It shows that it's on track to meet its full-year production guidance and is performing relatively well. However, will it be able to survive a potential fall in the price of oil?

Nostrum's daily production has averaged 38,901 barrels of oil equivalent per day (boepd) in the first nine months of the year. Its current production is above 44,000 boepd and its full-year guidance continues to be production of 40,000 boepd. Its main focus continues to be on the completion of GTU3, which should be delivered on budget in 2017. This will more than double Nostrum's production capacity and could lead to higher levels of profitability.

In terms of its financial standing, Nostrum has continued to reduce costs across its business. This is a prudent strategy, since the outlook for the oil price remains highly uncertain. Nostrum's cash of $100m provides a buffer, but its net debt levels of $860m are higher than at the end of the previous financial year when they were $786m. With net assets of $718m as at 30 June, Nostrum has relatively high balance sheet leverage. For example, its net debt to equity ratio is currently 110%.

Looking ahead, Nostrum is forecast to grow its pre-tax profit from £4m in the current year to as much as £93m next year. This puts it on a forward price-to-earnings (P/E) ratio of only 10.4. This represents a wide margin of safety, which is a requirement given the uncertain outlook for oil.

The OPEC issue

Although OPEC agreed to a cut in production at its recent meeting, the details on how it will do so have yet to be firmed up. In fact, OPEC ramped up production last month to a record level, which could make a supply cut more difficult to achieve. Therefore, it would be unsurprising for the oil price to come under pressure, since a deal to cut production may prove elusive.

In such a situation, Nostrum's wide margin of safety makes it appealing. However, its high debt levels increase its risk profile. Therefore, buying a larger and more financially stable peer such as Shell (LSE: RDSB) could be a good move. Shell has a net debt to equity ratio of just 39% even after the acquisition of BG Group. This provides it with the financial strength to not only overcome a period of weak oil prices, but also to make further acquisitions to strengthen its long-term growth outlook.

Shell is forecast to more than double its pre-tax profit next year. It trades on a forward P/E ratio of 14 and while that's higher than Nostrum's P/E ratio, Shell has a superior risk/reward profile. Therefore, even though Nostrum is likely to survive an oil price fall, Shell looks set to be the stronger performer even in tough operating conditions. As such, it's a better buy than Nostrum at the present time.

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Peter Stephens owns shares of Royal Dutch Shell B. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.