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Is Royal Dutch Shell Plc In Danger Of A Colossal Correction?

Shares across the mining and energy sectors have leapt broadly higher in recent weeks thanks to a robust recovery in commodity prices.

Fossil fuel leviathan Shell (LSE: RDSB) has been one of these beneficiaries. Since striking a 12-year trough of 1,277p per share back in January, the stock has leapt 33% to claw back above the 1,700p marker just this week.

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Shell’s resurgence has been underpinned by a bounceback in the oil price. The Brent benchmark reclaimed the $40 per barrel marker earlier this month,  up from the multi-year lows of $27.67 hit at the start of 2016.

Supply still surging

But this robust recovery has no tangible basis, in my opinion, with pumped-up buying activity now leaving the likes of Shell in danger of a shuddering correction.

Brent prices moved robustly higher following reports that Russia, along with OPEC members Saudi Arabia, Qatar and Venezuela, had floated the idea of a production freeze. This raised hopes of a much-needed output cut further down the line.

News surrounding a potential accord has gone quiet more recently, however, illustrating the colossal roadblocks on all sides. Not only has Russia previously played down chances of a freeze, citing the operational problems caused by the country’s harsh climate, but political faultlines across OPEC itself — and particularly between Saudi Arabia and Iran — also promise to scupper a deal.

Crude values have also benefitted from a weakening of the US dollar, brought on by falling expectations of Federal Reserve rate hikes in 2016. And further monetary loosening by the People’s Bank of China and the European Central Bank in recent weeks has also bolstered hopes of improving fossil fuel demand.

Demand in the doldrums

However, the steady stream of poor data from China illustrates the scale of the problem local lawmakers must overcome to prevent an economic ‘hard landing’, a catastrophic prospect for oil prices.

Recent trade data showed Chinese exports fall at their fastest rate since 2009 in February, down 25% year-on-year. And industrial production during the first two months of the year rose by just 5.4%, the worst figure since the 2008/2009 global recession.

With global crude inventories already at bursting point — US stockpiles hit fresh record highs for the fifth week on the bounce last week, at 523.2 million barrels — crude prices desperately need positive demand developments, or news of output cuts, in order to stay afloat.

What does this mean for Shell?

Well, Shell’s rocketing share price has left the business dealing on a monster P/E rating of 22.3 times for 2016, sailing above the benchmark of 10 times associated with high-risk stocks. The company is expected to suffer a 32% earnings slump this year, marking a second consecutive double-digit dip if realised.

And Shell does not have splendid long-term earnings prospects to justify this premium, either — the producer continues to slash capex budgets and sell assets to mitigate the effects of subdued oil prices, reducing its ability to eventually mount a comeback when crude prices improve.

With Shell’s weak balance sheet also expected to result in huge dividend cuts sooner rather than later, I believe there is plenty of scope for the firm’s share price to clatter lower.

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Royston Wild has no position in any shares mentioned. The Motley Fool UK has recommended Royal Dutch Shell. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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