This Big Oil Share Could Fall Further Than BG


LONDON -- Last week saw BG Group (ISE: BG.L) lose around 17% of its market value in two frantic days of trading, following the company's admission that production was only likely to grow by around 3% this year and was expected to be flat in 2013.

I think that investors have been caught in a classic growth share trap with BG Group -- and I believe that there is another FTSE 100 (UKX) oil share that could fall even further in the near future.

Expectation mismatch
At BG Group, what really went wrong was that investors' expectations had become divorced from reality -- and the company's third-quarter results made it impossible to ignore this trend any longer.

For several years, investors have kept BG Group's share price simmering on a price-to-earnings (P/E) ratio of 15 or more. Given that Royal Dutch Shell (ISE: RDSB.L) trades on a P/E of about 7.8, this effectively places a 100% "jam tomorrow" premium on BG Group.

"Jam tomorrow" is a classic growth share characteristic, which implies that future success should justify a share's present price. Until recently, BG Group delivered on its end of the deal, constantly expanding its resource base with new discoveries and ramping up production each year.

That's all changed. BG Group's production is now expected to grow by just 3% this year and is expected to be flat in 2013. Production forecasts have been downgraded due to new production taking longer to come online than expected, deferring it into future financial years.

In comparison to the savage sell-off inflicted on BG Group, markets were quite calm last week when BP (ISE: BP.L) announced in its quarterly results that production for the first nine months of 2012 was down by 5.3% on 2011. Similarly, investors were quite pleased that Shell had managed a 1% increase in production so far in 2012. It's all about expectations.

Writing on the wall
Although the City made much of its surprise over BG's downgraded production forecasts, in reality the writing has been on the wall for some time, and I think that BG Group is simply starting the transition from growth into maturity -- a process that will require its price to fall or its earnings to rise.

In BG's half-yearly report, the 2012 production exit rate was lowered from 750 kboe/d to 720 kboe/d and in a corporate presentation at the start of this year, BG made clear that production would fall between now and 2020 if its big new assets -- Brazil, Australia, and the U.S. -- were excluded. It's these big new assets that are suffering delays, deferring future production increases until at least 2014.

Given this information, flat production in 2013 shouldn't really have been a big surprise -- but City analysts were betting on a more positive result and so were their fund manager clients, until last week.

The next big faller
At the start of the article, I mentioned that I think there is another big oil share that could also be due for a painful rerating, as it leaves corporate youth behind and approaches middle age.

Tullow Oil (ISE: TLW.L) is smaller than BG Group but it is the fourth-largest oil share in the FTSE 100, with a £13 billion market cap. Tullow's share price has risen by 123% over the last five years and by a massive 1,440% over the last 10 years.

Growing a company like Tullow or BG is all about exploration success and production growth -- and Tullow has delivered in spades. Its exploration success rate is one of the best in the business and it managed to grow production by 35% last year.

A turning point?
This kind of production growth won't last forever and each successive discovery has to be bigger than the last in order to move the needle for investors. Tullow shares currently trade on a stratospheric 32 times last year's earnings. However, earning per share are forecast to grow by only 7% this year and 5% in 2013 -- a big drop from the huge gains seen in recent years.

Like BG Group, Tullow's dividend yield is very low -- below 1% at present -- so unlike BP and Shell, which provide yields between 4% and 5%, there is no reason to hold Tullow shares for income unless you bought them many years ago, at much lower prices.

I think that Tullow is likely to suffer a dramatic rerating of its share price at some point in the next year or so as its growth slows. BG Group is now being talked of as a takeover target and the same thing could happen to Tullow, should its market cap fall far enough.

Getting ahead of the game
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Roland Head owns shares in Royal Dutch Shell but does not own shares in any of the other companies mentioned in this article.The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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