Are these beaten-down oil explorers now too cheap?

Updated: 
tullow oil

The price of oil has been rising during the past two weeks, after OPEC members agreed on a deal to cut production at the end of November. Since the terms of this deal were first announced, non-OPEC members have also joined in with production cuts and, as a result, investor sentiment towards the oil sector has greatly improved.

However, at the beginning of this week, as shares in oil explorers such as Premier Oil(LSE: PMO) and Tullow Oil(LSE: TLW) rallied, data from one of the UK's largest retail stockbrokers TD Direct showed that substantially more investors on its platform were selling shares in these companies than were buying. This data seems to indicate that while City traders were buying Premier and Tullow to profit from their short-term bounce, long-term retail investors who invest through TD have been using the bounce to reduce or eliminate holdings altogether.

Buying and selling 

Interestingly, the data also showed that as investors were dumping Premier and Tullow, they were also buying shares in diversified oil major Royal Dutch Shell(LSE: RDSB). Based on this data, it appears that investors believe Shell is more likely to benefit from higher oil prices than either Premier or Tullow.

It's easy to see why the market has taken this stance. Both Tullow and Premier are overloaded with debt. At the beginning of November, Premier was forced to issue a statement reassuring its investors that its heavily delayed $2.6bn debt restructuring was on track, after a story emerged in the media speculating that lenders were looking to pull out of the deal. Any potential agreement is now not expected to come until the end of the year. 

Meanwhile, Tullow has net debt of $4.7bn compared to its market capitalisation of £2.9bn ($3.6bn). OPEC's production cuts and higher oil prices will help these companies, but oil prices will need to rise significantly above OPEC's envisaged trading range of $55 a barrel to $60 a barrel before Tullow and Premier can claim to have been pulled back from the precipice. Unfortunately, it's unlikely that oil will return to $100 a barrel anytime soon, which may be why Shell has become investors' preferred oil proxy.

Cutting costs boosting profits 

Shell's management has been working hard over the past two years to cut costs and bring down the company's oil production breakeven cost. Management is now targeting cash flow breakeven at $60 a barrel.  So, after oil's recent move higher, the group as a whole is close to cash flow profitability. What's more, Shell is not drowning in debt. Compared to Tullow and Premier the group's balance sheet is almost spotless, and management is aiming to dispose of $30bn of assets over the next few years to bring debt down further. On top of this, shares in Shell currently support a dividend yield of 6.7% -- almost double the market average.

The bottom line 

So overall, despite higher oil prices, it seems investors believe that Tullow and Premier have a bleak outlook. With such hefty mountains of debt to contend with, their valuations are almost irrelevant, which means that no matter how cheap they may seem investors may still be looking to sell. 

On the other hand, with its diversified operations, better-than-average dividend yield, and clean balance sheet, Shell remains an investor favourite.

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Rupert Hargreaves 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.