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Why Royal Dutch Shell plc and Tullow Oil plc are in danger of a colossal correction!

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While cooling crude prices may have put the brakes on surging commodity stocks in recent days, I believe previous heady gains leave many of the Footsie’s drillers and diggers in serious peril.

Oil giant Royal Dutch Shell (LSE: RDSB) has seen its share value march 13% during the past three months, propelled by Brent’s march back towards the $50 milestone. And Tullow Oil (LSE: TLW) has seen its stock price leap 29% since the start of February.

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But the colossal supply/demand imbalance washing over the oil market makes these breakneck rises difficult to fathom, in my opinion.

Multiple madness

Current earnings projections certainly suggest that Tullow Oil and Shell have plenty of room to fall.

Further revenues pain is expected to drive Shell’s bottom line 37% lower in 2016, the fourth annual dip out of five if realised. And this projection leaves the business dealing on a huge P/E multiple of 24.6 times.

The City expects sales at Tullow Oil to explode in the current year however, as maiden oil at its TEN project in Ghana begins to flow. Consequently the energy giant is expected to swing from losses of 113.6 US cents per share in 2015 to earnings of 6.1 cents in the current period. However, this forecast still leaves Tullow Oil dealing on a gigantic earnings multiple of 126.5 times.

Both firms clearly sail well outside the benchmark of 10 times, territory traditionally indicative of stocks with extremely high-risk profiles. Indeed, unusually-high multiples are usually reserved for companies with electric growth potential.

The worsening market dynamics of the oil industry don’t suggest that either Shell or Tullow Oil are worthy of such premiums.

Swimming in oil

Latest data from the Energy Information Administration (EIA) showed US crude stocks rose by 2.8m barrels in the week to 29 April, creating a fresh record of 543.4m barrels.

On the plus side, the EIA advised that oil output from the North American nation fell by 113,000 barrels per day week-on-week, to 8.83m barrels.

But more draconian cuts are needed to make up for production increases elsewhere. Indeed, total OPEC production rose to 32.64m barrels per day in April, a fraction off recent record highs and up from 32.47m barrels in March.

And the cartel’s output looks set to rise further in the months ahead, putting paid to Saudi Arabia’s desire for an output cut — Iran in particular is determined to hike pumping to levels not seen since Western sanctions kicked in.

Looking elsewhere, news that seaborne supplies from Russia increased to 3.12m barrels per day last month from 2.9m barrels in March somewhat undermines Moscow’s similar desire for a production freeze.

With doubts also persisting over the extent of oil demand this year and beyond, as China cools and the US economy stalls, I reckon that Shell and Tullow Oil could find themselves on the sharp end of a stark reversal in the weeks and months ahead.

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Royston Wild has no position in any shares mentioned. The Motley Fool UK has recommended Royal Dutch Shell B and Tullow Oil. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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