The analysts at RBC have just upgraded Tullow Oil to a target price of 90 pence. This is significantly up from the current 42 pence or so. That’s clearly a vote of confidence in Tullow’s prospects but the opinion of one set of analysts is just that, an opinion. What matters is the balance of opinions across all participants in the market.
Whether one additional opinion as to what Tullow’s price should be changes that price depends upon how many other views are altered by that publication of the new price target. Obviously.
There opinion is more mixed. JP Morgan thinks that something in the range of 62 to 70 is more likely. On the other hand, we seem to have DE Shaw increasing its short position in Tullow, meaning they think the price is to go down from here.
There’s a difficulty with valuing an oil exploration and production company. Clearly, as with Tullow in the past, the discovery of significant new fields – like those in Uganda of Ghana – will produce a significant upside for the Tullow share price. That’s the exploration side of matters.
With a producing oil company, the calculation can be a bit different. The oil price is a global one, we can all see – and feel when we fill up – it. Of course, if oil is high then the exploration value is leveraged to it but not as much as the production valuation is. The costs of pumping oil up from a field already found don’t change as the oil price does. So, a rise in the oil price could be seen as feeding straight through to the bottom line as profits.
We might expect a share price like Tullow to follow the same sort of path as a gold miner therefore. Highly leveraged to the price of gold/oil.
Except that doesn’t necessarily happen. For sometimes an oil company actually owns the oil it’s pumping and sometimes it doesn’t. There are varieties of blends of oil contracts but for most some part to a significant part of price movements in oil itself feeds through not to the company but to the owner of the resource itself.
It depends upon the jurisdiction exactly how the contracts are written but the more modern the contract and the richer the host country the more it is the Treasury, not the company like Tullow, which carries the costs or benefits of a changing oil price. Royalties and taxation are the key here. The value of the oil increasing in price goes to the government that is, not Tullow.
Again, it depends upon the exact contract for a specific field. But it’s this sort of complexity that means that we cannot just look to a rising oil price and think that an oil company like Tullow’s share price will automatically follow.
We’re stuck with those estimates of what the price will be from the analysts as a guide to that complexity.
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Tim Worstall is a freelance writer specialising in economics and the financial markets.