Why Royal Dutch Shell Plc Offers 20%+ Returns In 2016

In the last 18 months, the outlook for the oil sector has changed to a degree that few investors could have possible predicted. While in mid-2014 the price of oil was sailing well above $100 per barrel, it is now at less than half of that level. And, while many industry insiders were predicting oil at $200 per barrel over the medium term, now there are predictions for oil to reach just 10% of that level.

Clearly, most oil stocks have been hurt by the price fall and Shell (LSE: RDSB) is no exemption. Its shares are down by 31% in the last year and that is not without good reason. The company’s bottom line is expected to fall by 40% in the current year and, as such, investor sentiment is extremely weak.

Despite its problems, Shell appears to be adopting a sound strategy through which to overcome its present difficulties and post strong returns in 2016. For example, it is buying BG and this should provide a boost to the quality and diversity of its asset base. Furthermore, it is slashing exploration spend and seeking to offload non-core assets which offer a relatively unfavourable risk/reward ratio. And, with the company’s bottom line due to rise by 10% next year, investor sentiment could begin to improve as investors see that Shell may prove to be a winner (in terms of its competitive position) from the oil price collapse.

If investor sentiment was to improve, there is significant scope for an upward rerating. That’s because Shell trades on a price to earnings (P/E) ratio of only 12.4. Assuming a 20% rise in its share price, this would leave Shell on a P/E ratio of 14.9 which, for a dominant energy company forecast to grow its earnings by 10% next year, does not appear to be excessive.

In addition, Shell presently yields 7.5%. Certainly, there is a risk that the company fails to pay the current forecast amount of dividends in 2016 as a result of dividends only just being covered by profit. However, even shareholder payouts are cut by a third it would still leave Shell yielding a very impressive 5%. Add this income return to the potential for 20%+ capital gains and it is clear that buying a slice of Shell now could turn out to be hugely profitable in 2016 and beyond.

Of course, there is even greater potential for Shell to prosper in the longer term. That’s at least partly because of its extremely strong balance sheet which, realistically, could accommodate further debt so as to provide Shell with a larger war chest to take advantage of distressed asset prices. And, with the company’s cash flow also being relatively resilient, it appears to be well-positioned to emerge as a more dominant global energy player following the current ebb in the oil price.

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Peter Stephens owns shares of Royal Dutch Shell. 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.