Interactive Investor

Stockwatch: is now the right time to buy the oil majors?

15th March 2022 11:07

Edmond Jackson from interactive investor

Our companies analyst makes the case that oil prices are set to stay elevated and whether the current dip in stock prices is a useful buying opportunity.

How to define an investing stance on oil and related equities? Last week, the consensus shifted firmly towards oil prices being elevated for some time, underpinning the idea that economic prospects may worsen from a base-case scenario of stagflation to one of recession. 

In that event, and with the UK government brushing off calls for a windfall tax on big oil companies, integrated energy stocks such as BP (LSE:BP.) and Shell (LSE:SHEL) make sense as portfolio anchors. Their charts – like those of smaller companies – show them lagging oils 20% to 40% rally this year, as if the market expects the oil price to come back.  

Some lag is justified because companieshedging programmes will build in their limited short-term ability to capitalise on high oil prices.  

There is also the matter of writing down Russian interests for BP, which will cost up to £19 billion equivalent, relative to a near £70 billion market cap at around 350p a share currently.  

BP’s stock is down from £81 billion at 417p on 11 February, so arguably some of this is factored in and the rest can be comfortably offset if we are looking at say three years of elevated oil prices – the kind of timeline for Europe to find substitutes for Russian oil & gas imports. 

Falls at the start of this week 

Yesterday, Brent crude oil fell 4% to $108 a barrel, and precious and base metals also lost ground. This goes against pessimistsviews, given that they are a prime hedge for wealth in a stagflation scenario. 

BP and Shell were among the biggest fallers in the FTSE 100, with BP down 1.8% and Shell 1.3% versus the index’s gain of 0.3%. Weakness has continued in early trading today, albeit with the wider market down. 

The drops were initially in response to reports that Russia could be willing to compromise for peace in Ukraine. Time will tell if the two sides can agree and the plan sticks. 

But they also reflected another Covid lockdown in a key Chinese industrial area, plus hopes that US-sanctioned Venezuela will resume oil exports.   

Complexities in challenge to substitute Russian oil & gas  

I recall how, in the 1991 and 2003 invasions of Iraq, oil stocks were perceived as the best thing to hold – yet they slumped immediately it became clear that US military strength had prevailed. 

In 2022, however, unless Putins regime collapses soon, it could be years before sanctions reverse; meanwhile, it is tricky to re-orient supplies in a complex web of global politics. 

Germany is also stalling in the international sanctions drive, given it relies on Russia for 40% of its gas. 

Boris Johnson has already been criticised over his attempts to deal with Saudi Arabia, which together with the United Arab Emirates is shunning communication with President Biden. Various disputes exist between the US and these Arab nations, and they sense a chance for retaliation with Biden facing mid-term elections in November.  

Potentially, the US could promise to defend Saudi and the UAE from Iran, and also settle the war in Yemen on Saudi/UAE terms. But appeasing Saudi would not sit well with US Democrats after the assassination of Khashoggi and the latest executions of 81 people.  

Meanwhile, Iran has just fired missiles at an alleged Israeli base close to a US compound in Erbil, the capital of Iraqi Kurdistan – hardly a promising environment for Biden to start negotiating.  

It is therefore going to take time to get results; and even if demand for fuel is checked by high prices, there are strong reasons why prices will stay above those pre the Ukraine war. 

Yield elements at least start to lend support     

Around 350p, BP trades on a 12-month forward price/earnings (PE) just below 6x and offering a 4.8% yield, while Shell at £19.00 is on a 6.5x PE with a 4.2% yield.  

According to consensus forecasts, earnings cover for BP and Shells dividends is 3x to 4x, with Shell’s cover slightly better. Historic tables show earnings strongly backed by free cash flow, with Shell also superior. Its stock could thus increasingly be perceived as attractive for conservative investors as people wake up to sustained higher oil & gas prices. 

Do not be fooled by Shells higher” price, which relates to 7.6 billion shares issued versus 19.5 billion for BP. 

Shells 20-year chart – a sideways-volatile trend from around £19 – is also better than BPs decline from over 600p. BP has however faced greater exceptional events: the 2010 Gulf of Mexico spillage, and now departure from Russia after three decades of investment. 

On the established track record, you would favour Shell as a first means of capitalising on higher oil prices; however, there is a case also for BP given its potential for radical re-invention as a ‘net zero company. 

You can spend endless time divining specifics, but when it comes to big integrated energy companies – those selling products as well as producing them – you are largely taking a view on the underlying commodities.

BP - financial summary
Year end 31 Dec

reporting in US$

  2016 2017 2018 2019 2020 2021
Turnover ($ million) 183,008 240,208 298,756 278,397 161,291 157,739
Operating margin (%) -1.6 2.6 5.0 2.8 -13.6 8.6
Operating profit ($m) -2,928 6,310 14,852 7,680 -22,000 13,502
Net profit ($m) 115 3,389 9,383 4,026 -20,305 7,565
Reported EPS (cents) 0.6 21.4 46.1 19.7 -100 37.6
Normalised EPS (cents) 45.3 44.9 62.2 71.8 -3.0 4.9
Op. Cash flow/share (cents) 56.7 95.5 114 126 60.1 117
Capex/share (cents) 88.6 83.6 83.1 75.6 60.8 54.1
Free Cash flow/share (cents) -31.9 12.0 30.7 50.7 -0.7 63.2
Dividend/share (cents) 37.7 40.0 39.7 41.3 31.5 21.4
Earnings cover (x) 0.0 0.5 1.2 0.5 -3.2 1.8
Cash ($m) 23,528 24,223 21,340 20,965 29,527 30,961
Net debt ($m) 34,772 39,007 44,459 56,481 52,399 38,826
Net asset value ($m) 95,286 98,491 99,444 98,412 71,250 75,463
Net asset value/share ($) 49.0 49.7 49.5 48.6 35.2 38.2

Source: historic company REFS and company accounts

What risk of oil demand destruction leading to recession? 

This is likely the chief risk to a medium-term bull case for oil & gas stocks. 

The current oil price spike results from a rise in global demand following the worst of Covid, which has suddenly hit supply disruption by way of sanctions on Russia.  But the fact is that every recession in the last 80 years has been preceded by a hike in oil prices.  

Some 60 million extra barrels have been released, but the industry is calling for double that and repeatedly. If a political juggling act is achievable, it would still take around three months to implement.

There will also the potential contribution of higher food prices to the crisis, though as yet I would steel for stagflation as more likely than recession.

Shell - financial summary
Year end 31 Dec

reporting in US$

  2016 2017 2018 2019 2020 2021
Turnover ($ million) 233,591 305,179 388,379 344,877 180,543 261,504
Operating margin (%) 0.4 5.3 8.7 6.7 -14.3 10.6
Operating profit ($m) 858 16,246 33,552 24,747 -25,741 27,828
Net profit ($m)  4,575 12,977 23,352 15,843 -21,680 20,101
Reported EPS (cents) 58.0 180 280 195 -278 257
Normalised EPS (cents) 57.5 195 241 299 196 172
Op. Cash flow/share (cents) 261 430 636 520 437 578
Capex/share (cents) 280 251 276 283 213 243
Free Cash flow/share (cents) -19.0 178 360 237 225 334
Dividend/share (cents) 188 188 188 188 65.0 89.4
Earnings cover (x) 0.31 0.96 1.49 1.04 -4.28 2.88
Cash ($m) 18,781 20,192 26,484 17,624 31,830 36,857
Net debt ($m) 73,695 65,473 50,340 78,800 76,184.0 52,229
Net asset value ($m) 186,646 194,356 198,646 186,476 155,310 171,966
Net asset value/share ($) 22.9 23.4 24.3 23.7 19.9 22.4

Source: historic company REFS and company accounts.

Shell has proven virtue as an early stock to buy during crisis 

Even if recession does ensue, it is time to be aware of credentials for relatively more defensive companies, which is why I have also drawn attention to smoking and defence stocks partly on yield considerations. 

A key reason why I drew attention to Shell as a buy” at around £10 on 17 March 2020 – as a prime early buying candidate in the markets Covid sell-off – was an awareness that over decades this tends to pay off. 

That call was initially successful with a rebound to over £15 early that April, although Shell did then gradually ease to £9 late in October 2020. The emergence of credible Covid vaccines a few weeks later then triggered a bull trend to over £20.60 early in February 2021. 

Shell is only involved in around a £300 million equivalent write-down of its assets as it exits joint ventures with Gazprom, relative to end-2021 net assets of £132 billion equivalent. 

BPs far greater hit could be said as compromising its asset backing for a worse-case economic scenario, and its stock is on a 22% premium to end-2021 net asset value of 293p equivalent. But bear in mind that accounted numbers may not fully reflect oil & gas value. Shell trades at a lower 12% premium, another case for favouring it over BP. 

I suggest awareness of both stocks during the trading months ahead. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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