Over the past month, shares in Royal Dutch Shell (LSE: RDSA)(LSE: RDSB) have outperformed almost all of its peers in the oil and gas sector. Its Class B shares rose 4.7% over a one-month period, whilst shares in BP (LSE: BP) and Tullow Oil (LSE: TLW) fell 10.8% and 29.9%, respectively. With very few exceptions, oil and gas stocks have been massively sold off as the price of Brent crude oil, an international oil price benchmark, fell 14% to just under $50 per barrel over the past month.
So how did shares in Shell buck the trend?
There are two main reasons. Firstly, Shell reported much better than expected results for the second quarter of 2015. Shell’s underlying earnings fell 35% to $3.36 billion, but this still exceeded analysts expectations. This was helped by a very strong performance from its downstream operations, where earnings more than doubled to $2.96 billion, from $1.35 billion in Q2 2014.
Secondly, the market seems to be gaining confidence in its BG acquisition. Rumours had been spreading in the market that the deal with BG would only pay off if the oil price recovers to at least $90 per barrel. Simon Henry, Shell’s chief financial officer, disagrees with this, and insisted the deal would work at $70 per barrel. Management expects the “value” synergies from the deal are likely to be in the billions of dollars as Shell benefits from economies of scale in LNG and its trading and marketing activities.
Is Shell still a better buy?
Probably not. The divergence in the share price movements of different stocks in the oil and gas sector have greatly shifted the relative valuations between the stocks.
Smaller oil and gas producers have seen their share price fall much more dramatically. A significant proportion of them, including Tullow Oil, benefit from very low costs of production and have relatively modest debt levels.
Tullow Oil, the Africa-focused oil and gas producer, has underlying cash operating costs of just $15 per barrel. So, even with today’s oil price, Tullow is still generating significant cash flows to fund an expansion in production and exploration activity. The company does not face any major debt repayments until 2019, and has sufficient financial flexibility in the medium term.
Despite recent falls, BP’s valuations do still seem more expensive than Shell’s. BP’s 2015 forward P/E of 15.8 compares less favourably to Shell’s 14.1, but there are many reasons for why BP deserves a more expensive valuation multiple.
BP faces fewer execution risks, and its smaller size makes itself a potential acquisition target. The company is being more cautious in the low oil price environment, by lowering its break-even oil price target to $60 a barrel for new developments. Despite a 64% fall in underlying earnings for the second quarter of 2015, operating cash flow is resilient, having just fallen by 20% to $6.3 billion. By contrast, Shell’s operating cash flow fell 30% over the same period, despite much stronger profitability.
Shell seems to be making risky bets on higher oil prices. It is spending more than a billion dollars each year on its Arctic drilling project and it has yet to find any oil. At the same time, it has the unenviable task of integrating BG’s assets into its business and divest a vast array of its own assets to pay down the debt that will be gained from funding the acquisition.
Shell’s sizeable downstream operations could be a double-edged sword. Although its refinery operations reduces the volatility of earnings for the company, this also makes it less of a recovery play on higher oil prices. Downstream margins, particularly for its trading and marketing activities, would likely fall back to their historical levels, if oil prices recover and stabilise.
