BP plc & Royal Dutch Shell Plc: Overvalued Or Undervalued?

bpThe shares of BP (LSE: BP) (NYSE: BP.US) and Royal Dutch Shell (LSE: RDSA) (LSE: RDSB) have lost 5% and 7% of value, respectively, in the last month of trading.

The pressure is building on oil prices. The macroeconomic landscape and fundamentals haven’t really changed in the last couple of quarters, however. So, is this an opportunity too good to pass up for investors? Or should BP and Shell shareholders worry about the prospects for these two oil companies?

The Bulls

1. Investors may have overreacted in recent weeks. The bulls argue that oil prices will soon return above $100, and both BP and Shell will benefit from macroeconomic trends. China is slowing down, but with gross domestic product still growing above 7% a year it will continue to provide support to oil prices. On Thursday last week, Brent crude hit a 27-month low just above $91 per barrel — but is this level sustainable? Read on.

2. There is talk of structural changes in the oil market, with Saudi Arabia looking to compete fiercely on prices. I think that’s unlikely to have an impact over the long term. In fact, a cut in production from OPEC shouldn’t be ruled out in November. My take: the supply-demand imbalance in the oil market means that oil producers should benefit in the long run.

3. Of course, BP’s equity valuation is exposed to litigation risk. News emerged last week that BP had asked for a court ruling regarding the 2010 Gulf of Mexico disaster to be overturned. There is more downside than upside here, in my view. Still, BP stock offers plenty of value at 445p, where it currently trades. As far as Shell is concerned, the bulls argue that its restructuring plan is set to yield dividends. I agree. The fair value of BP stock is 500p, while the shares of Shell should comfortably trade 10% higher. Shell will become a leaner machine and returns will improve over time, in my view.

Neither the shares of Shell nor those of BP are expensive, but both BP and Shell are cyclical businesses that could struggle if the global economy collapses. Enter the bears.

royal dutch shellThe Bears

Think of oil prices dropping by another 10% to the end of the year. How realistic is that? Much depends on OPEC.

“While some expected OPEC to adjust the group’s output target of 30 million barrels per day (bpd) for 2015, any cut may not be big enough to spur a bounce in oil prices,” Reuters reported last week. As such, both BP and Shell are risky investments at this economic juncture.

“Markets here are a little tippy,” a banker from the US recently told me. “Small cap stocks are getting hammered, VIX inching up, spreads widening, high yield market selling off: (…) just another dip to buy, or not?” he asked me.

If the market heads south, the shares of BP and Shell will underperform the broader market, the bears kindly remind us. And if the macroeconomic landscape deteriorates, downside could be up to 35% under a worst-case scenario, they insist. 

Well, I don’t buy into that…

Oil companies are not the most obvious bet in this market. I appreciate that. But if you are serious about investing in the equity market, you should learn more about a business whose shares could surprise investors in weeks ahead.

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.