MARKET COMMENT
BP vs Shell

By David Kuo (TMFDragon)
October 23, 2003

Who in their right minds would want to buy oil shares?

After all, the profitability of oil companies is inextricably linked to the price of crude, which in turn is controlled by a small group of oil exporters that gather regularly to fix the price and production levels of black gold. It has not gone unnoticed that the shenanigans of those oil ministers that make up the oil cartel, OPEC, can have a devastating effect on the profits of oil companies.

Take, for example, the oil price collapse in 1997 following the Asian economic downturn. The OPEC-instigated increase in oil production saw crude prices collapse from over $20 a barrel to just $10 a barrel. That in turn caused BP's (LSE: BP)(NYSE: BP) earnings to crumple 69% in 1998 while Shell (LSE: SHEL)(NYSE: SC) saw its income tumble 97%.

Naturally, shares in both companies fell as profits caved in, though fascinatingly, the decline was nowhere as severe as their disintegrating profits. And that is one reason why many investors like oil shares!

When Shell's profits vanished, its shares tumbled 57% and when BP's income evaporated, its shares declined 27%. Both companies maintained their dividend payments throughout the period, which led to a rapid recovery in the shares once profitability was restored a year later.

I recently wanted to add some oil shares to my tech-heavy portfolio, and was faced with the knotty problem as to whether to buy Shell or BP. There are, interestingly, some key differences between the two oil giants, which had a bearing on my final decision.

Although both businesses are defined as integrated oil companies, BP is seen to be more of an upstream operator. This means that it has a bigger interest in oil exploration. Shell, on the other hand, is generally seen as downstream merchant. In other words, it is more concerned with refining and transporting oil.

In times of high oil prices, upstream companies, such as BP, benefit because each barrel of oil that is pumped from the ground commands a better selling price. And provided costs are kept reasonably steady, those higher prices should feed through into bottom line profits.

However, high oil prices are generally seen as being less good for downstream outfits, such as Shell. Each barrel of oil that Shell buys for its refineries will obviously cost more, and that can have an impact on its refining margins.

That said, trying to predict the future price of oil is a mug's game and certainly beyond my capabilities. Instead I turned to some of the other differences that include a better use of capital by Shell. However, I felt that the variations were not big enough to lose any sleep over. In the end it came down to which company had the better dividend yield, and Shell came out on top by a hair's breadth.

Even based on today's valuation, there is little to differentiate the two businesses. BP and Shell match each other, stride for stride, in terms of their P/Es, gearing, and price-to-book valuation.

Furthermore, BP is expected to pay a full-year dividend of 15.9p, which puts the shares that trade at 414p on a prospective yield of 3.8%. Shell, which released third-quarter results today, is trading at 375.25p. A dividend payout has been pencilled in for 15.6p this year. This puts its shares on a slightly better prospective yield of 4.1%, which should keep my portfolio well lubricated with a regular flow of cash.   

The writer owns shares in Shell.