Is It Safe To Stick With BP plc And Royal Dutch Shell plc, Or Should I Get Out?

I’m a self-confessed tragic for statistics. According to Wood Mackenzie, around £55 billion of oil and gas projects in the North Sea and Europe could be shelved if the oil price keeps falling.

Where does that leave BP and Royal Dutch Shell?

A recent report by Company Watch shows a third of Britain’s listed oil and gas companies are currently in danger of running out of working capital or even going bankrupt. The risk management group says that 70% of the UK’s publicly listed oil exploration and production companies are now unprofitable.

So what about BP (LSE: BP) (NYSE: BP.US), and its current projects? The oil giant has three major undeveloped projects at present (Pitu, Sunrise and Liberty). They all require an oil price above US$100 per barrel to break-even. Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US) has five undeveloped projects in total (Carmon Creek, Bosi, Gato Do Mato, Bonga, Yucatan and Athabasca). They all require an oil price of at least US$95 per barrel to break-even. So yes, it’s not looking good on that front.

Morgan Stanley says the price of oil could fall to as low as US$43 per barrel. We know the price could spike back upwards if OPEC cut supply, but the harsh reality is that no one actually knows what the price is going to do over the medium term. It’s a market, and markets are unpredictable. What we do know is that both BP and Royal Dutch Shell are better placed to handle a longer-term fall in the price of oil than the industry’s smaller players. Actually, BP and Shell are said to be in talks about a possible merger to further improve their economies of scale given the current oil price. A combined group would significantly cut costs and give the resulting company increased pricing power.

Assuming the price falls further, to the low 40s, many of the smaller players will be swallowed up by other, larger, cashed-up players, or will simply go bust. Analysts say firms with projects in the Arctic are particularly vulnerable.

What if the oil price rebounds in 2015?

I spoke with one veteran investor on the weekend who was actually bullish on oil. He contributes much of the recent fall in the price of oil to reduced global demand and the rise of Shale in the US. He argues that OPEC is playing the long game and will cut production at the first available opportunity — but only once the Shale market has been given the ‘once-over’. He also argues that China, the US and the UK will all contribute to an improved global economic performance in 2015.

So, if the price does indeed rise you’ll know that — if you’ve looked at the share prices of both BP and Royal Dutch Shell — both companies will look incredibly attractive from a valuation point of view.

In the meantime, despite the price drop, are they still reasonable investments?

BP is sitting on a price-to-earnings ratio of 3-4 times. It’s also producing a dividend yield of close to 6%. The oil producer’s operating margin — down to 2%, has obviously been hurt by recent events in the energy market. Royal Dutch Shell has a better operating margin at 6% (but its earnings outlook isn’t as good as BP’s). It’s sitting on a price-to-earnings ratio of 5.3%, with a dividend yield of 5%.

Given these numbers, it’s clear both companies have a solid foundation but have been materially hurt by the steep fall in the price of oil. This Fool believes both companies will survive (and have the potential to grow) over the longer term, so if you do opt out now (sell) you will be realising significant losses (depending on your exposure). Indeed, if the price falls further, there’s a real chance BP and Shell will merge, creating a potentially exciting investment opportunity.

Personally, I favour Shell. I have said it before, and I’ll say it again, it doesn’t seem prudent to willingly throw your money behind a company like BP when you know part of your investment won’t be directed towards growing the company but rather tied up in litigation. Shell, on the other hand, says it’s eyeing investment opportunities in integrated gas projects — a smart move.

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David Taylor 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.