Oil Price Fall Shouldn’t Worry BP plc Or Royal Dutch Shell Plc

bpUntil recently, the price of oil had been making higher highs as unrest in the Middle East continued. However, in recent weeks there has been a sharp fall, with the price of Brent Crude falling from $115 per barrel to under $111 per barrel as Libya announced that it would be increasing its supply to the global energy market.

Of course, as producers of oil, a higher oil price generally means more profit for BP (LSE: BP) (NYSE: BP.US) and Shell (LSE: RDSB) (NYSE: RDS-B.US), as it does not impact upon costs but does help to boost revenue. However, a sharp fall in the oil price does not spell disaster for either company, with them both offering great long-term potential.

Super Cash Flow

As mature companies operating in mature industries, both BP and Shell have extremely strong cash flow. For instance, Shell’s net cash flow from operating activities last year was over $40 billion. However, due to Shell’s relative stability, it was able to invest the full amount in capital items, which could lead to higher profits in future. Similarly, BP’s strong cash flow allows it to invest heavily in the company’s future projects and this could lead to increased profitability over the medium to long term.

Furthermore, strong and stable cash flow allows a generous dividend to be paid. At current prices, BP yields 4.5%, while Shell yields 4.4% — both of which are well above the FTSE 100‘s (FTSEINDICES: ^FTSE) yield of around 3.3%. Part of the reason for above-average yields is that both Shell and BP trade at relatively attractive valuation multiples, with Shell having a price to earnings (P/E) ratio of 11.6 and BP trading on a P/E of 10.7 – both well below the FTSE 100 P/E of 14.2. Therefore, there appears to be potential for both companies to see their current valuation gap versus the index narrow over the medium term.

Looking Ahead

Certainly, a continued and prolonged fall in the price of oil would be likely to squeeze profitability for both Shell and BP. However, neither company’s share price appears to reflect a sustained higher oil price and, furthermore, the investment case for both companies is not wholly dependent upon significant increases in the top-line or bottom-line over the short to medium term.

Indeed, the closing of the valuation gap versus the index, a great yield and long-term profit growth from vast capital expenditure are the key reasons to invest, with short-term fluctuations in the oil price being a feature of the oil sector rather than a reason to invest. As such, both Shell and BP appear to be great long-term investments at current price levels.

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Peter owns shares in BP and Shell.