During the early 2000s the global economy was growing as fast as its ever grown, as both the West and emerging markets pushed ahead. The rise of China meant that commodity prices went through the roof. The oil price reached levels that were previously unheard of.
This was the time when the oil industry was the place to be. Just as people invested in tech start-upsat the time ofthe tech bull market of the 1990s, people were investing in small-cap oil stocks during the Noughties, because this waswhere the money was being made.
This was an incredible investment. Wasnt it?
One of the companies createdduring this era of fevered commodities speculation was Afren (LSE: AFR). From the IPO launch price of 54p in 2005, the shares rose to 171p. Clearly this was an incredible investment. Wasnt it?
The share price fell precipitously when the financial crisis hit, but that was the case with most small-cap companies. The stock price recovered quickly, and by the early 2010sAfren was even starting to turn a slim profit. Even in late 2013,the share pricewas as high as 169p.
The business was confidently investing in more exploration and production facilities across the world. This was an ambitious firm, aiming to grow oil reserves andoil production. After all, withcommodities so expensive, the more you could produce, the moreprofitsyou would make.
But what happens as you try harder to increase production, is that you take more and more risks. Conducting seismic surveys, building rigs and drilling wells all cost money a lot of money. And if you are not currently turning much of profit, then allthis investmentmeans only one thing: more debt.
This is like thetech bubble of the 1990s
Now most companies have a certain amount of net debt but too much is dangerous. As of the end of 2013, Afren had $739 million of net debt.
Then, in the middle of 2014, something else happened: the oil price started falling. This meant that a business that was gradually beginning to make profits was suddenly loss-making. So then you know what will happen to the share price.
At the time I am writing this article, Afrens stock is now priced at 5.95p a share. That makes the total market capitalisation of this firm 65 million. So how can it pay its debt? Its quite simple it cant.
Just as most of the internet start-ups that grew out of the 1990s tech bubble made very little (if any) money and eventually went to the wall, Im afraidmany small-cap oil sharesare likely tosuffer a similar fate. The Afren story is a casebook example of why knowing which shares to avoid is as crucial as knowing which shares to buy.
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