Investors looking to buy into the oil and gas sector would probably first think of investing in Royal Dutch Shell (LSE: RDSB). Shell is, after all, the largest company in the FTSE 100, with annual revenues of around $265bn. The company is also well diversified, between oil and gas, upstream and downstream, and geographically too.


This means Shell’s earnings are relatively stable and it benefits from a greater level of financial flexibility. So, although upstream earnings fell by 89% in 2015, overall group earnings fell by a more modest rate of 53%, as widening downstream margins acted as a cushion against falling oil prices. Operating cash flows have held up even more resiliently, down just 34% in 2015.

What’s more, Shell is hugely attractive from an income standpoint, with its shares currently yielding 8.0%. But, on the downside, its dividend policy does not look sustainable, as energy prices look destined to stay lower for longer. Free cash flow fell into negative territory in the fourth quarter of 2015, which means its dividend (and a significant proportion of capex) is being funded by new borrowings.

Although Shell has the financial flexibility to raise its level of indebtedness, it’s not a sustainable long term strategy. Thus, markets expect a strong likelihood of a dividend cut taking place in the near future, with dividend futures pricing in a 36% dividend cut in 2017.

Shell also faces significant near-term execution risks. It has the difficult tasks of integrating the assets from its takeover of BG Group and achieving the cost synergies needed to make the deal work. History is not on its side, as past M&A deals have had a poor track record of adding value for Big Oil’s shareholders. In addition, the company needs to sell some $30bn in existing assets to reduce the strain on its balance sheet, at a time when investor sentiment is near record lows.

A better buy?

Shares in Shell may have fallen by 22% over the past 52-weeks, but I think the real opportunities lie with the smaller oil producers. Many small- and mid-cap producers have seen far steeper declines in their share prices, and I’m particularly interested in the low-cost players which have enough financial flexibility to weather the downturn in prices.

Genel Energy (LSE: GENL) is one of them. Shares in the company have fallen 82% over the past year, and are valued at just 0.13 times book value, or 13.8 times expected 2017 earnings. This compares favourably against Shell, which trades at 0.92 times book value and has a 2017 forward P/E of 17.0.

Although Genel is a pure-play exploration & production (E&P) company — which means its has no downstream operations to soften the blow of falling oil prices — it has a very strong balance sheet. It has net debt of just $239m, and a cash balance of $455m. Moreover, Genel is being owed some $400m in arrears by the Kurdistan government for export payments, which the government is beginning to pay back.

What’s most attractive about Genel is its low production costs. Its cash flow break-even oil price is less than $20 per barrel, well below Shell’s, which is estimated to be above $60 per barrel. Genel’s oil focus is another positive, since liquids yield higher price realisations than natural gas in the current trading environment.

This means that even in today’s low oil price environment, Genel is in a position to generate plenty of free cash flow. And when oil prices eventually recover, Genel’s E&P focus means the company is better positioned to benefit from widening margins.

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Jack Tang has no position in any shares mentioned. 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.