Which Big Oil share faces the toughest year

Updated 23rd January to correct fund ownership percentages

• Oil prices surge, but the outlook remains bleak
• Shell (and other oil shares) a terrible investment since mid-2014
• The Stoics
• Weighing the heavyweights
• ShellBG
• Shell is ‘winning’ the argument
• Rich and indebted

Finally some relief for the oil industry.

Prices staged a near near-parabolic rally on Friday from lows that were a stone’s throw from $25 a barrel a day ago, according to Reuters data.

But news that an Iranian oil tanker was heading to South Korea, among the first Tehran-registered vessels to depart since sanctions were lifted, underlined that global oil fundamentals would not be changing any time soon.

As my colleague Fawad Razaqzada wrote earlier, talk of a bottom in prices is very likely premature.

For that reason, even the most robust oil firms will continue to face severe share price pressure for the medium term at least

That means oil industry investors will face further total return losses, exceeding those of the broader market

ROYAL DUTCH SHELL A SHARE TOTAL RETURN VS. FTSE ALL SHARE TOTAL RETURN

Please click image to enlarge

Buy and hold at all costs?

For the medium term, the collapsing values raise an obvious question for investors: hold or fold?

Well, in fact it’s probably correct to assume the ‘fast money’ has already deserted.

That leaves large institutions with very long-term plans that enable them, or perhaps compel them to keep grasping these shares no matter how much the stocks cheapen.

Sticking with our example of Royal Dutch Shell Plc. ‘A’ shares we see that institutions owning only about 1% of the outstanding stock were classed within Thomson Reuters’ data as being ‘high turnover’, or frequent buyers or sellers.

ROYAL DUTCH SHELL A SHARE: FUND OWNERSHIP TURNOVER

Source: Thomson Reuters

Many of these institutions will of course be holding the stock on behalf of savers and fund investors, including you and me.

Drilling-down on big drillers

However, digging into the innards of the strongest global oil exploration and production giants—AKA ‘Oil Majors’ is worthwhile—for three key reasons.

• Many of them remain high-quality equities with strong dividend profiles and proven long-term potential that should return to the forefront, when commodity prices finally recover
• They’re cheap. For the value hunter, the qualities outlined above may make them candidates to consider for a portfolio
• For the trader, divining the weakest and the strongest may offer a window into their relative futures over the next few months and more, when oil prices will once again almost certainly face fresh challenges

OIL MAJORS: A RELATIVE VALUATION MODEL

Please click image to enlarge / source: Thomson Reuters

Numbers we ran

Our fairly basic comparative valuation was carried out on the basis of a number of key metrics, listed and explained below.

• Enterprise value/Ebitda – this tells us how efficiently debt and capital is used to generate underlying earnings. A lower multiple is usually judged to be better
• Dividend yields – higher values can show better pay-outs to shareholders, but as shares fall they can also signal risk that dividends may be cut
• Net debt/Enterprise Value – this tells us how much of a company’s total capital is debt
• Net debt/Ebitda – does a company’s debt look scary compared to underlying earnings? This ratio answers that question
• Free cash flow – how much cash is left in the bank after all expenditures? Our table has latest reported amounts and estimates
• Operating margin (LTM) – how much revenue did the oil majors have left after production costs over the last 12 months? It’s an efficiency differentiator
• Total Revenue Compounded Annual Growth Rate over three years; taken from last fiscal year
• Crude oil production in millions of barrels per day – even in the current low-oil-price environment, companies that drill the most oil (preferably at lowest cost) still earn the highest revenues
• Cost of Goods Sold (COGS) – not quite the same as the oil industry-specific Current Cost of Supplies, but COGS is analogous to CCS and therefore useful

Shell out

First we should note that Tullow has been left in our list even though it is not an Oil Major.

We’ve left it there as an example of the carnage that collapsing of oil prices have wreaked on the majority of oil companies which are in fact small-to-medium-sized firms.

Aside from that, we were immediately inclined to rule out Shell and BG, for quite obvious reasons.

The former is taking over the latter at a cost of £47bn, an amount that has chilled some investors to the bone.

The coming takeover has probably made Shell the worst-performing stock of the remaining true ‘Oil Majors’ in our number-crunching table.

Our stock price chart below, rebased to a year ago to the day, demonstrates that whilst shares of all the biggest European and US oil firms have been slashed, Shell shares have been slashed the most.

There is of course an alternative way of viewing this scenario.

Shell could in fact represent the best value Oil Major, probably in the world, due to having the biggest share price fall.

However that best value would be predicated on Shell not going ahead with its humongous gas acquisition.

There’s little sign that Shell management’s resolve is wobbling.

OIL MAJORS’ SHARES REBASED TO A YEAR AGO

Please click image to enlarge

Standard response is the minority

Some of Shell’s largest investors have dissented to the purchase, most notably insurer Standard Life.

However, Standard is falling deeper into the minority, as more and more giant shareholders voice their approval, ahead of crucial shareholder votes next week.

Shell’s fifth-biggest investor, Norges Bank Investment Management, on Friday said it would vote for the deal.

Funds including Kames and Rathbone have also backed the deal recently.

It looks like investors on the whole want to give Shell the benefit of the doubt.

On the other hand, perhaps the consequences of not doing the deal now—probable disruption to senior management and a £750m break fee—are proving almost as powerful incentives.

Generally speaking, Shell itself has suggested that whilst combining the two groups would save $3.5bn a year by 2018, the revenue economics of the deal would only make sense if oil prices were above $50 a barrel.

Also, earnings would not accrete if oil remained below $65 by 2017.

As a whole, the deal would break even at $60 a barrel.

All this means that arguments against the takeover are based on the risk that oil prices could stay lower for longer than 2017 or 2018.

On the one hand, if Shell is right that oil prices will rise toward the levels it envisages at the given time, the £47bn outlay for Shell to boost its oil and gas reserves by 25% and take a leading share of the natural gas industry will appear reasonable.

On the other, even if oil rises to around $60 a barrel in a year, buying BG will be an extremely expensive deal.

Dividends cost jobs

At least Shell has pledged to maintain dividend payments at $1.88 (£1.30) per share this year and at least that level next year.

That will keep the yield above the FTSE 100 average.

Shell’s div yield is probably not flashing a warning sign yet.

To bolster its balance sheet ahead of the massive hit (and afford more comfort in paying the dividend) Shell is selling a further $30bn in assets, cutting $15bn in costs and investments and will unfortunately sack 10,300 people.

Exxon least levered

After looking past Shell, we can then weed out the oil majors with the most eye-watering debt.

Spain’s Repsol is the most leveraged, and among the largest oil producers it produces the least—just 139,000 barrels per day last fiscal year.

France’s Total SA and BP vie for second and third lowest dependence on leverage, but neither could match Chevron’s and Exxon’s slim 12.8% and 8.7% respective portion of debt capital as a percentage of total capital.

Even so, none of the above produced more oil than BP, which drilled a barely conceivable reservoir-like volume of 2.6 million barrels a day.

Even though Reuters had trouble coming up with a reliable figure for how much it cost BP to produce that much oil, for UK investors, right now BP seems to have advantages which its domestic rival does not.

Cashing out

Of those oil majors that have chosen to run a positive cash balance—many have not—Shell is the richest.

The Anglo-Dutch giant had $13.19bn last fiscal year compared to No.2 BP with $10bn.

Shell will keep the lead in terms of cash in its next full year, but with a much depleted $3.6bn, according to forecasts.

However if Shell was the highest-cost major oil producer in its last fiscal year, as our grid suggests, that is a point deducted.

With total debt at $45bn, the lowest production rate versus its most massive rivals, and revenue growth falling faster than Repsol, Shell shares hinge even more on perfect execution (plus a big oil price recovery).

As for the weakest large E&P firm, ConocoPhillips’s 6.9% slide in revenue growth and relatively meagre production have left it as the poorest stock price performer of all.

Net debt that would swamp earnings more than three times, a negative operating margin and negative cash balance, immediately draw attention to its dividend yield.

In context, having a yield almost akin to BP’s does flash a warning in Conoco’s case.

We could also certainly query Repsol’s 10.4% yield on similar grounds.

Shell’s dividend yield running at 10% ahead of what the year has in store for it doesn’t seem particularly positive either.