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BP plc and Royal Dutch Shell plc may never be this cheap again

Image: BP. Fair use.

Shares of BP (LSE: BP) and Royal Dutch Shell (LSE: RDSB) have risen by 30% and 40% respectively so far in 2016. If you bought the shares earlier this year, you may be thinking about taking profits. If you didn’t buy, you might think that you’ve left it too late.

Personally, I’m holding onto my shares. Both companies offer a 7% dividend yield, and I believe that the shares are likely to rise further as the oil market recovery continues.

I hold this view for two reasons. The first is that global oil supply is still exceeding demand. The market hasn’t yet rebalanced. The second reason is that by historical standards, BP and Shell shares remain very cheap.

Supply versus demand

The world’s oil producers are still pumping more oil each month than they can sell. But this surplus isn’t as big as it was a year ago.

Figures from the International Energy Agency suggest that during the second quarter, world oil supply was about 300,000 barrels per day higher than oil demand. That’s down from a surplus of 1.8m barrels per day during the fourth quarter of 2015.

We don’t yet know exactly when supply and demand will come into balance. But if OPEC does manage to agree a deal to cut production later this month, this rebalancing process could happen faster than expected.

Once the market does return to balance, I expect a sustained oil price of perhaps $55-$60 per barrel. But if the market moves to a deficit, oil could spike much higher than this.

When it comes, it could be big

It’s worth remembering that commodity prices rarely move smoothly and often overshoot. A small change in the balance of supply and demand can trigger a massive shift in prices.

Coal is a good example. The price of coking coal (used for making iron ore) has risen from $100/tonne to $300/tonne since August. That’s a 200% increase in three months.

The trigger for this move was a cut to Chinese coal production. This has caused supply to fall slightly below demand. The price will probably fall back somewhat if production rises again, but investors who weren’t invested in coal back in the early summer have missed out on this recovery story.

BP and Shell are still cheap

The other reason why I’m still happy to rate Shell and BP as a buy, is that based on each firm’s historical earnings, their shares remain cheap.

BP and Shell both trade on a multiple of 8.2 times their 10-year average earnings per share. This ratio is known as the PE10. It’s a popular choice with value investors, who believe that a company’s earning power tends to revert to historical average levels over time.

Although oil prices aren’t likely to return to $100 per barrel, costs are now much lower than they were, and spending is under tight control. Profits at both firms should respond well to any sustained increase in the price of oil.

In the meantime, patient shareholders at both firms are being rewarded with a 7% dividend yield. These generous payouts aren’t covered by earnings and could still be cut. But I think this is unlikely — and even a 30% reduction would still give an attractive 4.9% yield.

More high-yield excitement?

Although I'm bullish about the oil market, it's worth remembering that the oil recovery has already taken much longer than expected. That's why I've also been investing my cash in a number of other dividend stocks with strong growth potential.

Several of the shares in my own portfolio feature in the Motley Fool's latest report, 5 Shares To Retire On. If you're looking for dividend stocks with real growth potential, I'd urge you to take a look.

This exclusive report is free and without obligation. To download your copy, just click here now.

Roland Head owns shares of BP and Royal Dutch Shell. The Motley Fool UK has recommended BP and 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.