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This Oil Stock Is Scorching Hot Right Now (Is It Still a Buy or Will It Burn Investors?)

Matthew DiLallo, The Motley Fool

Shares of W&T Offshore (NYSE: WTI) have enjoyed an impressive run lately. The stock was up another 10.5% this week, which pushed its year-to-date rebound to more than 45% (and we're only two weeks into the year). In fact, since last September, shares are up more than 150%.

That said, even with those gains, the stock is still down more than 70% over the past five years, suggesting it could have more room to run. However, while that upside potential might be tempting, this oil stock comes with a boatload of risk.

A natural gas flare from an offshore drilling rig.

Image source: Getty Images.

Drilling down into why this oil stock has been so hot

Two factors have driven W&T Offshore's rebound. First, crude oil has been on fire and was recently in the $60's, which is its best level in three years. In fact, oil has risen more than 40% since just last summer. Fueling that rebound has been a significant improvement in oil market fundamentals, thanks in part to OPEC's efforts to drain supplies. Those higher oil prices, if they hold up, would enable W&T Offshore to generate more cash flow from its production, which it could use to pay down debt or drill additional wells.

Meanwhile, more specific to W&T Offshore was its most recent operations update from late December. The offshore-focused oil driller noted that two of its three most recent exploration wells struck pay dirt. One well achieved an initial production rate of 1,100 barrels of oil equivalent per day, which outperformed the company's pre-drill expectations. Meanwhile, a second well also encountered oil and should start producing in the next 12 to 15 months. These wells hinted that the company still has the potential to uncover a substantial amount of oil.

An offshore oil platform with the sun rising in the background.

Image source: Getty Images.

Of risk and reward

W&T Offshore could unearth more of that oil in the coming year since the company has "number of high-quality, low-risk exploration opportunities under way or planned for the near future that offer substantial potential," according to comments by CEO Tracy Krohn in the third-quarter press release. Assuming success, these wells will come online over the next year, adding incremental production and cash flow. In addition to that, the company estimates that its drilling program could unlock as much as $2.2 billion of new oil reserves in the coming years, which is a substantial payday for the $1.5 billion company.

That said, what stands between W&T Offshore and those incremental supplies is its limited financial resources. The company said that it would need to invest about $317 million in drilling wells to unlock these underwater oil resources. That's a lot of money for a company that could only afford to spend $125 million on drilling last year because of lower oil prices and its tight financial situation. One of the things holding the company back is nearly $900 million of high-cost debt on its balance sheet, the bulk of which it took on to stay afloat during the oil market downturn. Because of that, it would make more sense for the company to divert any excess cash it pulls in from higher prices to paying down debt instead of drilling more wells.

Until the company shores up its balance sheet, it remains much too risky for the average investor, especially when compared to other oil stocks with stronger balance sheets and more visible growth prospects. For example, at $50 oil, Encana (NYSE: ECA) would have the money to grow cash flow at a 25% compound annual rate through 2022. Furthermore, Encana's plan would generate a whopping $1.5 billion in excess cash over that time frame, giving it money to pay down debt, increase its dividend, or buy back shares.

This oil stock is too hot to touch

W&T Offshore's stock has been scorching hot this year because investors are gambling that rising oil prices will give the company the cash it needs to repair its balance sheet and drill lucrative offshore wells. However, that's a high-risk bet because crude isn't back on solid ground just yet, with many analysts expecting oil to fall back into the $50's this year. Because of that, investors shouldn't touch this oil stock Instead, investors are better off considering a company like Encana, which can thrive even if crude takes a tumble.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.