Shares in Shell (LSE: RDSB) have surged by 17% in the last three months, with the rising oil price being a key reason behind this. Of course, there’s still a long way to go before the price of black gold and the price of Shell reach their previous highs. In the case of Shell, its shares reached 2,570p in May of last year, which is their 10-year high. For them to hit that level again, they would need to rise by 54% from their current level.
On the one hand, this could be achieved before the end of the year if the company’s share price continues to rise at the same pace as it has done in the last three months. While this is entirely possible, it seems unlikely, since the price of oil may not increase at a rapid rate. That’s simply down to a major imbalance between demand and supply, which is showing little sign of rapidly reversing over the short term.
As a result, Shell’s comeback is likely to be a more gradual affair, although one that’s very much on the cards. A key reason for this is the company’s low valuation, which provides significant upward rerating potential. For example, Shell trades on a forward price-to-earnings (P/E) ratio of 12.2 and so for its shares to trade at 2,570p, it would require a rating of 18.8. While high, this isn’t unreasonably so, which means that even with Shell’s financial year 2017 profitability assumed to continue over the medium-to-long term, a share price of 2,570p is achievable.
Size matters
Of course, Shell’s net profit is unlikely to flatline in the long run. That’s at least partly because there’s the prospect of a higher oil price as the current level becomes uneconomic for a number of producers.
On this front, Shell has a major advantage. Due to its size and scale, Shell should be able to maintain and even gain market share over the medium-to-long term as higher-cost producers struggle to survive. This should allow it to maximise profitability and with it having the potential to engage in future M&A activity, Shell also has the capacity to boost its financial performance through acquisitions due to a strong cash flow and modestly leveraged balance sheet.
Therefore, Shell’s P/E ratio may not need to rise to as high as 18.8 in order for its shares to reach 2,570p. However, if the company is able to deliver upbeat profit growth, then a rising rating could be the end product as investor sentiment improves.
Clearly, Shell’s future is highly dependent on the price of oil and realistically, for its shares to hit 2,570p once more, the price of oil will need to move higher. However, even if it doesn’t, Shell has the financial firepower to become a more dominant player within the oil and gas space, which should lead to greater profitability and a higher share price in the long run. As such, buying Shell now seems to be a sound move.
