I can often be found espousing a the benefits of a contrarian strategy to anyone I can corner in a lift, by the water cooler or at their desks, so you won’t be surprised that the recent dive in oil price has me sniffing around for unloved bargains.
Sturdy oil majors BP (LSE: BP) and Shell (LSE: RDSB) have fallen 23% and 12% respectively since the oil price began to dive, and my contrarian sense thinks this might present an opportunity.
Contrarian investing resonates with a lot of people, I think, because in principle it sounds so easy. However, oftentimes I have to remind people, and myself, of the wise words of Mr Buffett:
“A contrarian approach is just as foolish as a follow-the-crowd strategy.”
After all, you wouldn’t sprint across a road simply because everyone else was waiting patiently for the traffic to stop. Oftentimes, the markets correctly forecast disasters.
Instead, I feel it is important to carefully take into account the risks surrounding an investment before taking the plunge. Today I’m going to analyse the headwinds facing both of these mega-cap oilies to see if the they are worth buying.
Danger’s near…
The oil price has plummeted to just below the standard $60 stress test cost employed by most oil majors, so evaluating companies before buying for a dividend is incredibly important.
Worryingly, in a recently leaked memo, BP’s CEO Bob Dudley admitted: “In many parts of BP, we have higher costs and larger teams than other companies operating at a similar scale.”
He also said job cuts are likely as some lower-margin projects are shut down and middle management are stripped away from back offices to reduce costs and simplify the company.
Finance Officer Mr Gilvary also recently said BP had the “flexibility to trim into next year if that’s what we need in a new world of oil at $70 or $60.” None of this points to good news really, and while the company will survive current prices, a further drop in oil price could see the dividend endangered.
BP also owns 20% in Russian oil major Rosneft, and it is proving more hassle than it is worth. It contributed $460m to BP’s earnings last year and looks certain to suffer amidst the downturn in Russia, but as a shareholder BP must rely on Rosneft paying dividends like any other investor.
Analysts at Barclays think it unlikely that Rosneft will have enough cash flow to cover debt responsibilities this year, and the dividend looks under threat as a result.
Goldman Sachs has predicted that oil majors will have to cut capex by 30%, and if the dividend from Rosneft halts, I would anticipate further cuts to be necessary for BP.
This could spell an extended period of zero growth.
Of course, on top of all this BP is still wading its way through the legal proceedings from the disaster in the Gulf of Mexico. Four years on, the company has admitted that it still can’t give a reliable estimate for the total cost, which is incredibly worrying when you consider it has sold over $40bn in assets mainly to cover costs.
However, you could be well rewarded for taking on these not insignificant risks. BP trades on a dirt-cheap PE ratio of 5.5x 2013 earnings and yields 5.6%, although how long these payments can last at lower oil prices is uncertain.
A protective Shell
Shell comes without the added risk of a Russian oil partnership, a huge comfort in itself. It also has size on its side when compared to BP. With a market cap of £208bn, it dwarfs ‘small’ £74.6bn BP. It truly is a monster, and is probably one of the safest oil companies around.
This should set it up to weather the worst of the oil price fall, with plenty of assets to sell to support earnings. Don’t get me wrong, I’m certain Shell will also experience a downturn in growth and earnings as long as oil prices stay low, it just seems less likely to me that Shell will encounter serious issues.
Trading on a PE of 14 and yielding 5%, Shell doesn’t look as cheap as BP, but I feel the yield looks secure.
One final point I’d like to make is that no one predicted an oil price crash on this scale, and so I’m certainly not inclined to listen to predictions of it imminently returning to higher prices, and I think basing your investing strategy on that alone is risky.
In the very long term, energy demand is set to rise roughly 40% by 2035, and so I expect the price of oil, a finite resource, to stabilise. However, I have no reason to believe I can predict the direction of the oil price at the moment, and shares in both BP and Shell could prove a poor investment even at today’s prices.
However, Shell looks by far and away the safer income play, so if you are desperate to grab a stable company at a bit of a discount then it could be a good pick. BP has so many uncertainties surrounding it that I feel an investment here is at least partly speculative.
