1 Crucial Thing to Beware Of With Dirt-Cheap Oil & Gas Stocks

Editor’s note: Nam Cheong’s share price was previously incorrectly stated as S$0.21 in the table below. It has been corrected. The Motley Fool deeply regrets the error.

According to a report by bourse operator Singapore Exchange Limited, there were 54 shares listed in Singapore, as of November 2014, which belong to the oil & gas sector.

Of those 54 shares, there are 27 that some investors may of think as being dirt-cheap right now – that’s because they are valued at less than 0.5 times their latest book values, according to data from S&P Global Market Intelligence.

Put another way, these 27 stocks – which include Ezra Holdings Limited (SGX: 5DN), PACC Offshore Services Holdings Ltd (SGX: U6C), Ezion (SGX: 5ME), and Nam Cheong Ltd (SGX: N4E) – have a market capitalisation that’s at least 50% lower than their net book value (total assets minus total liabilities).

Ezra, PACC, Ezion, Nam Cheong PB ratio table (2)
Source: S&P Global Market Intelligence (click table for larger image)

With such low valuations, the 27 stocks look like big bargains, don’t they? That’s especially so when we consider that the SPDR STI ETF (SGX: ES3) – an exchange-traded fund mimicking the fundamentals of Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a price-to-book ratio of 1 at the moment.

But for any investor who’s eager to jump into them purely because of their low valuations, there’s something important to think about and that is, how closely do their reported book values match current economic realities? I say this because of the recent experience of the U.S.-based oil & gas asset owner Paragaon Offshore.

Earlier in the month, the company had proceeded to file for Chapter 11 Bankruptcy in the U.S. In some of the related documents, the company stated that it had property, plant, and equipment (PP&E) on its balance sheet that had a reported book value of US$1.11 billion as of 31 December 2015. This PP&E “primarily consists of drilling rigs, drillships and related equipment.”

But in the same documents I linked to, Paragon Offshore revealed that its PP&E only had recovery values that were 2% to 11% of the stated US$1.11 billion in book value if they were liquidated. In other words, the current economic worth of the company’s drilling rigs, drillships, and related equipment is essentially only US$24 million to US$124 million. The reason for the big discrepancy is explained by Paragon Offshore (emphasis mine):

“The Debtors’ [referring to Paragon Offshore] equipment is primarily early vintage and is not readily marketable as operating equipment in the current market environment. The low end recovery scenario assumes all Paragon rigs are scrapped… Based on current rig transportation costs to scrap yards and steel scrap rates, it is highly likely that scrapping would represent a negative cash flow event. On the low end recovery, a $0 value per scrapped rig has been conservatively included.

On the high end recovery, it has been estimated that each rig, on average, could bring $1.75 million in net proceeds based on an optimistic case given prior market transactions for vintage equipment when oil prices were at higher levels. Additionally, a 10-20% recovery has been estimated for certain rig equipment that could potentially be separated from the rig.”

As you can see, Paragon Offshore’s assets did not have economic values that are anywhere close to what was stated in the books. Depending on the type of asset an oil & gas company in Singapore possesses, there’s a possibility that the value of its assets based on current market realities are much lower than what’s given on paper. And if that is true for any oil & gas stock that has a low price-to-book ratio, then what appears to be a dirt-cheap bargain may not be so.

And just to be clear, I’m not suggesting that oil & gas stocks in Singapore are engaging in any accounting impropriety. Instead, what I’m trying to bring across is the important reminder that even a proper adherence to accounting rules by a company may at times result in significant deviations between the accounting value and real economic value of its assets.

If you’re trying to bargain-hunt by sieving through the oil & gas sector in Singapore’s stock market for companies that are priced at big discounts to their asset values, please do keep Paragon Offshore’s experience in mind.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.