As the price of Brent crude oil has rebounded 25% from last week’s low of $42.23, investors may be beginning to feel that they have missed out on a perfect opportunity to buy oil stocks on the cheap. Although it seems that traders had overreacted to fears of slowing demand growth in the wake of China’s “Black Monday”, longer-term fundamentals remain bleak.
Oil supply continues to outstrip demand, and this has led crude oil inventories to reach all-time highs. Production growth from the US and OPEC countries have been more resilient than initially expected, as drilling costs have fallen and rig/well productivity have improved.
Shares in BP (LSE: BP) have fallen by almost 3% today, as weak manufacturing data from China dragged global stocks lower today. Its shares are still some 8% higher than last Monday’s low of 326 pence, but we could be heading back to those levels again.
BP is showing progress in controlling operating costs and the company has announced ambitious plant to cut capital spending over the next few years, but it would face challenges to cutting capital spending further. To protect its dividend and preserve its free cash flow, BP is divesting $10 billion worth of assets over the next few years. Although divestments may help to alleviate its deficit of free cash flow in the short term, it would also lead to lower production and earnings in the longer term.
Royal Dutch Shell (LSE: RDSA)(LSE: RDSB) has fared somewhat more resiliently than BP because of its larger downstream operations and its downstream focus on Europe. Refiner margins in Europe have improved more substantially in recent months, and this helped its downstream earnings more than double to $2.96 billion in the second quarter of 2015.
The recent volatility in crude oil prices is likely going to lead to further increases in its downstream earnings, but it is difficult to see trend of ever widening refiner margins continue for much longer. On the other hand, the bearish direction with oil prices is likely going to have a much greater impact on its upstream earnings. With Shell’s earnings set to fall further, the company’s share price could follow suit.
Buying shares in BG Group (LSE: BG) could be a cheaper way of investing in Shell. With crude oil prices having fallen significantly since the deal with Shell had been announced, the spread between BG’s current share price and the offer made by Shell has widened considerably. This could reflect that investors believe the prospects of the deal reaching completion under the current terms is less likely, or investors are simply becoming risk averse.
The spread between BG’s share price today and Shell’s offer of 383 pence in cash and 0.4454 Shell B shares is currently 148 pence, which is 15% of BG’s share price. For investors who believe that the deal would still go ahead, buying BG shares could be a very appealing proposition.
There are many reasons why the deal is likely to go ahead. Shell, with its long-term planning, is likely to pay little attention to the volatility in oil prices in the short term. Its management expects the deal would generate “value” synergies in the billions of dollars, and pay off with longer term oil prices at $70 per barrel. In addition, regulatory scrutiny is unlikely to scupper the deal.
Jack Tang 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.