Gamble of the week: A beaten-up oil play

If you own shares in a company, it goes without saying that you don’t want to hear bad news. Shareholders in this oil company have had bucket loads of it recently. At the end of July, the company suspended its chief executive and chief operating officer – it is investigating whether or not they have been paid money from an unauthorised source.

The situation deteriorated further last week, when the ongoing fighting in Kurdistan forced it to suspend operations at its key project in the country. It wasn’t producing much oil, but was expected to make a big contribution in the years ahead.

To rub salt into the wound, credit-rating agency Standard & Poor’s posted a negative outlook on the firm. It said the unauthorised-payments investigation might make banks reluctant to lend to Afren (LSE: AFR), which might hamper its ability to develop its big Nigerian oil projects.

All this doom and gloom has wreaked havoc with the share price, which is down 40% this year. However, a quick glance at its share-price chart will tell you that investing in this company has been a roller-coaster ride for some time.

That’s largely because investors are – quite reasonably – very wary of oil companies that make most of their money from Nigeria. It’s become a very hostile place to do business.

Oil majors such as Royal Dutch Shell and Italy’s ENI have been plagued by the theft of their oil and damage to their assets. The Nigerian government also seems intent on taking more money from oil companies, meaning less money for investors.

Afren share price chartHowever, Afren had a good year in 2013 with record revenues and cash flows. At its annual results presentation, the company was very bullish on its prospects.

Projects in Nigeria and Kurdistan, and exploration projects in Kenya, Tanzania and the Seychelles, were set to boost oil production by more than 10% a year for the next five years.

Once the big investment spending phase to develop the fields had peaked, investors could look forward to seeing lots of free cash flow pour in. And analysts are still predicting a big profit growth. According to Bloomberg, they expect trading profits to fall to $502m this year, rising to $851m in 2016.

These forecasts should always be taken with a big pinch of salt – but what is undeniable is that Afren shares look very cheap. They trade at a 12% discount to their net asset value and offer an earnings yield of nearly 18%, based on this year’s forecast trading profits.

Some might argue that the risks here mean the shares should be cheap. It’s a fair point – but the shares might bounce if Afren’s problems abate.

Verdict: a risky buy

Merryn

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