For many investors, the oil sector may appear to be a rather risky place to invest at the present time. After all, there is a major global demand/supply imbalance and, with the level of oil production showing little signs of a dramatic fall, the outlook for the commodity’s price is not particularly positive. As a result, the top and bottom lines of oil companies across the globe are likely to come under a degree of pressure – even with cost cuts and efficiencies set to come through.
However, a different view of the oil sector may prove to be a more accurate one. Certainly, volatility is likely to be high, but with the valuations of oil companies having tumbled, it could be argued that wider margins of safety are now on offer. And, more importantly, the risk of further declines in valuations may have been lessened.
Take, for example, Shell (LSE: RDSB) (NYSE: RDS-B.US). Its share price has slumped by 29% since its 2014 high and, with its profit set to fall by 34% this year, such a fall is perhaps well-deserved. However, it puts Shell on a very appealing valuation, with it having a price to book (P/B) ratio of just 1 and a forward price to earnings (P/E) ratio of only 11.1. This is exceptionally low for such a major, well-diversified and financially sound business and indicates that it has a wide margin of safety and a relatively appealing risk/reward ratio.
Furthermore, while the oil price may move lower in the short run, Shell has the potential to be significantly rerated upwards. Part of the reason for this is that Shell is one of the most financially sound oil companies in the world. As a result, it should be able to survive the low oil price environment better than nearly all of its rivals and use the period to its advantage, in terms of making further efficiencies, increasing market share and also making acquisitions.
And, despite having a beta of 1.4, Shell offers relative stability and longevity, so that when the oil price does enjoy a period of growth, Shell should be able to take full advantage and post impressive share price gains from improving investor sentiment.
Of course, other oil stocks are also very cheap at the present time. While Genel (LSE: GENL) may lack the financial strength and diversity of Shell, it has a superb management team (with Tony Hayward having been promoted to Chairman recently) and a highly lucrative asset base.
Certainly, cash flow issues are a threat to the business, with Genel recently announcing an exploration suspension due to a lack of payment from the Kurdistan Regional Government (KRG). However, with Genel trading on a P/B ratio of just 0.5 and a forward P/E ratio of 12.7, it has a very wide margin of safety which indicates that its shares may be rerated upwards over the medium to long term.
