Over the past 24 months, shares in Royal Dutch Shell (LSE: RDSB) and Premier Oil (LSE: PMO) have plunged by 28% and 84% respectively, excluding dividends. 

The big question is, do these declines present an opportunity for investors or should Shell and Premier Oil be avoided until the price of oil recovers?

Drastic changes 

Both Shell and Premier have made drastic operating changes to their businesses over the past 12 months to cope with the low-oil-price environment. What’s more, both of the companies have relatively robust balance sheets. 

Premier has net debt of $2.2bn, four times forward earnings based on the current oil price. However, the company still has $400m cash on hand, $850m of unused borrowing, the support of its banks and is completing a deal to buy all of Eon’s cash-generative North Sea fields. Premier’s flagship Solan project is set to begin production later this month.

Shell is also considered to be in robust financial health. Even with oil prices where they are today, Shell’s balance sheet is clean, and net gearing is less than 20% — excluding debt from the acquisition of BG Group.

So, both Shell and Premier look to be financially sound, which means they could be great ways to play a recovery in oil prices.

That being said, from an investment perspective, Shell and Premier are both very different opportunities. Shell is one of the UK’s largest companies, and the group’s shares have bond-like qualities. On the other hand, Premier’s shares come with a lot more risk, but if oil prices recover to the level they were at in early 2013, Premier’s shares could rise tenfold, presenting an attractive risk/reward ratio.

Portfolio approach 

If you’re interested in Premier but are worried about the level of risk, a 50-50 mini oil portfolio (as part of a wider diversified portfolio) comprised of Shell and Premier, will help reduce risk while maximising your upside. 

Indeed, a £2,000 portfolio invested equally in Shell and Premier would generate a yield of 3.8% per annum, thanks to Shell’s hefty dividend yield of 7.6%, and you’ll have access to Premier’s potential upside if the price of oil recovers. If Premier’s shares returned to the level they were at this time last year (150p), the portfolio would double in value to £4,000. If Shell’s shares also returned to the level they were at this point last year, the portfolio would be worth around £4,600, a gain of 130% excluding dividends.

Maximising gains and minimising losses

Overall, if you’re looking to play a recovery in oil prices, the best way to do so is to use a combination of a large-cap integrated oil major like Shell, and a small well-run producer like Premier. Shell will provide the stability and income while Premier opens the door to explosive capital gains if oil prices recover. However, if oil prices don’t recover and Premier goes under, at least you won’t lose your shirt as Shell will continue to provide a regular income.

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Rupert Hargreaves owns shares of Royal Dutch Shell B. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.