Why Are BP plc And Royal Dutch Shell Plc Not Trading At Cheaper Prices?

The big news story of the past six months, and which looks set to dominate the news agenda for a lot longer, is the astounding collapse of the oil price.

Just this week the West Texas Intermediate benchmark dived to fresh six-year lows around $44.10 per barrel, and the analyst community expects prices to remain in the doldrums for some time to come — Goldman Sachs noted this week that prices should trade around the $40 mark for much of the first half of 2015.

And today the US Energy Information Administration (EIA) advised that domestic crude stocks have risen to the highest on record, at some 407 million barrels, a further indication of the worsening supply/demand balance in the oil market.

In this environment it is hard to see how the world’s energy majors like BP (LSE: BP) (NYSE: BP.US) and Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US) can get back to a position of sustained earnings growth any time soon.

Shell’s sales slide underlines market woes

Indeed, Shell announced today that earnings during October-December registered at $4.2bn, missing analysts’ forecasts and slipping from $5.3bn in the prior quarter. In a bid to protect the balance sheet from a crumbling top line, the company announced it was slashing $15bn from its capital expenditure budget for the next three years, further undermining its growth outlook.

Given the murky outlook for the oil industry, I believe that BP and Shell should be trading at much lower prices than those currently on offer. Needless to say both companies have experienced severe share weakness since the oil benchmark started to tank in the summer, with prices declining 18% and 16% respectively during the period.

But a relentless stream of earnings downgrades means that firms’ prices still remain at odds to their earnings prospects. Indeed, Shell trades on a forward P/E multiple of 11.5 times, while BP deals on an even higher multiple of 13.3 times. I would consider a figure closer to the value benchmark of 10 times to fully reflect the array of risks facing the companies.

At these multiples, Shell would be trading at 1,850p per share, down considerably from 2,136p at present. And BP would trade at 320p, a significant reduction from the recent price of 424p.

But with oil cartel OPEC committed to continue pumping well into the future, project scalebacks in the North American shale sector likely to take some time to take hold, and economic growth in China and the eurozone heading down the sink, even these prices could be considered heady as further forecast cuts look likely. With this in mind I believe that investors should give both companies short shrift.

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Royston Wild 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.