Should you buy Royal Dutch Shell plc and Premier Oil plc before oil hits $50?

Crude prices in the $30 range may have splashed red ink across financial statements throughout the industry, but Royal Dutch Shell (LSE: RDSB) withstood the lowest prices in over a decade better than most. As Brent crude climbs closer and closer to $50, is now the time to jump on the Shell bandwagon? Q1 profits slumped 83% year-on-year to $814m, but avoiding falling into the red when the average price Shell received for each barrel of oil fell to $29 is still a sign of the company’s strength. Shell’s resilience in the face of crude prices is due to its large downstream assets that brought in $1.7bn in profit in Q1 alone.

Cost cuts

As has happened across the industry, Shell’s costs have fallen dramatically as it fired workers, cut production in high-cost areas and squeezed suppliers for better deals. All of these actions mean Shell now believes it will be cash break-even with crude in the mid-$50 range. Prices reaching this level soon will be imperative as operating cash flow in Q1 was a meagre $700m, well below the $3.7bn paid out in dividends.

However, Shell’s balance sheet can withstand uncovered dividends for some time as gearing rose to 26% at quarter end, reflecting the $54bn acquisition of BG. The combined company is now the world’s largest commercial supplier of liquefied natural gas (LNG) so this deal will make sense if natural gas continues to grow in popularity as a cleaner fossil fuel. But whether LNG and oil prices can return to their previous highs becomes the crux of the matter for investors. If fears over the rise of American shale oil and falling dependence on fossil fuels are overblown, Shell’s high dividends and diversification into LNG could make it a solid bet at close to a low point in the cycle. However, if a major shift in energy is upon us, oil supermajors’ massive projects could prove economically unfeasible over the coming years. 

Debt load

With a gearing ratio of 75%, Premier Oil (LSE: PMO) desperately needs crude prices to hit $50 and keep rising. The company’s $2.6bn in net debt is due largely to investments in its North Sea Solan and Catcher fields. Solan’s production, which began last month, will be helpful, but with UK assets’ operating costs a staggeringly high $30/bbl last year, Premier won’t be making a large dent in its mountain of debt at current prices.

The good news for Premier is that overall operating costs were $16/bbl thanks to low-cost assets in Vietnam and Indonesia. However, the company’s medium-term future has been largely tied to the UK North Sea due to the Solan and Catcher projects initiated when oil prices were many times higher than they are now. Analysts are expecting Premier to be lossmaking for at least the next two years, and the additional debt this will incur is reason enough for me to stay away from such a high-cost producer even if crude hits $50 soon.

Of course, even investing in less-indebted, lower-cost-of-production oil & gas producers comes with risks since these firms are at the mercy of the volatile global energy market. For investors attracted to the sector for its reliable dividends and long-term potential but turned off by their highly cyclical nature, I recommend reading the Motley Fool’s latest free report, Five Shares To Retire On.

These five companies offer oil supermajors’ global reach and great dividends, but their fortunes aren’t tied to the whims of OPEC or American shale oil producers.

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