The most important element of Tullow's (TLW) future value creation is finding oil via exploration. The company's record in this area during the early 2000s was easily one of the best in the world. From 2003 to the present, the firm increased its reserves from 18 million barrels of oil equivalent to 1.4 billion barrels of oil equivalent.
But can Tullow repeat the degree of its past successes? A string of disappointing offshore drilling results during the past two years, for example non-commercial wells in French Guiana, Mozambique, and Mauritania, has shaken the market's faith in the strength of the firm's exploration program, as has poor exploration results for the industry at large; 2013 was a terrible year for offshore exploration in general. A bear argument has gained traction that the excellent drilling results of 2005-11 are unlikely to be consistently repeated. Indeed, if the recent weak results continue, Tullow's stock may be fairly valued or even overpriced.
We currently don't share this pessimistic view, and believe the recent string of poor exploration results does not materially diminish Tullow's outlook. The reality is that each high-risk high-impact exploration well faces a high chance of failure, in a good year, 30% or more of wells will be successful. This makes the pattern and timing of new oil discoveries lumpy over shorter periods. For even the best companies, this will create lumpiness in terms of when discoveries are made. However, for multiyear periods we think this volatility will even out and Tullow possesses more than enough exploration skill and know-how to create significant value via the drill bit each year, net of the capital it invests.
Tullow has accumulated significant knowledge in exploring for oil in areas long ignored by other firms. Because the company has been among the most active explorers in certain geological trends and basins, this knowledge base can be put to work to find new oil discoveries, which in turn provides further useful intelligence for future drilling campaigns. Managed correctly, this can be a virtuous exploration cycle that increases the likelihood of making future oil discoveries.
One of Tullow's biggest risks is a substantial and prolonged drop in oil prices, which would reduce operating cash flows, slow development plans, and reduce the value of its properties. Another major concern is that much of the company's value is concentrated in just a few African countries – Ghana, Uganda, Kenya – where political stability and country risk are legitimate concerns. Additional risks Tullow faces include prolonged periods of unsuccessful exploration wells, cost overruns on project developments, and the risk of changing fiscal terms in its key operating countries.
