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Why I Believe BP plc And Royal Dutch Shell Plc Are Perilous Investment Traps

Needless to say, the effect of an eroding oil price has proved catastrophic for the world’s fossil fuel specialists in recent months.

Indeed, a 47% decline in the Brent benchmark since June has been followed by heavy share price declines at both BP (LSE: BP) (NYSE: BP.US) and Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US) during this period.

Earnings picture does not merit premium prices

Prices in the oil producers have regained much ground since mid-December’s troughs, however, when reports first emerged that US shale producers have begun aggressively scaling back output in response to nosediving black gold prices. But this strong share price recovery has again cast doubt on whether the scale of the risks facing the two oil majors are not baked into the price.

Shell’s stock has flipped 13% higher from December’s three-year lows of 1,989p per share, while BP has advanced 21% from the winter nadir of 373.25p, the cheapest since autumn 2011.

Consequently, the former now changes hands on a P/E multiple of 16.7 times forward earnings, above the benchmark of 15 times which represents attractive value for money. And BP deals on a hugely inflated earnings multiple of 19.6 times.

Are dividend projections realistic?

Still, current broker forecasts suggest that both BP and Shell offer exceptional value for money for dividend hunters. Even in spite of persistent earnings turbulence, both firms have continued to reward investors with reliable payout hikes and share buybacks, and the City expects these businesses to remain red-hot income picks.

BP is predicted to raise last year’s total payment of 39 US cents per share to 39.8 cents in 2015, creating a monster yield of 5.7%. Meanwhile Shell is predicted to increase 2014’s dividend of 188 cents to 191 cents this year, producing a sector-smashing 5.5% yield.

However, I believe that investment in either of the oil plays remains perilous business despite the impact of reduced shale output from North America. With major producing nations like those of OPEC continuing to pump with a vengeance, and global economic growth in the doldrums, I reckon that the oil price could be set for fresh turmoil.

With this in mind, dividend coverage of 1.1 times at Shell leaves little wiggle room should earnings experience sustained pressure, missing the security watermark of 2 times by some distance. And things are even worse over at BP, where the forecasted payout for this year outpaces predicted earnings of 36 cents per share.

Meanwhile, Shell’s assertion last month that “nearterm oil prices will dictate the buyback pacehas raised doubts that the firm’s balance sheet could support generous shareholder rewards should the bottom line come under pressure. And significant investment scalebacks at both firms has also raised doubts over their capital strength. In light of a fragile outlook for the oil market, I believe that both growth and income hunters could be left sorely disappointed.

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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.