With the price of oil having risen from $28 per barrel earlier this year to around $50 per barrel, many investors may feel as though the worst is now over. Certainly, such a rapid gain in the price of any asset indicates a step change in investor sentiment and looking ahead, the price of oil could rise yet further. However, with there being a major imbalance between the supply of and demand for oil, its price could easily come under further pressure in the short-to-medium term.
In such a situation, it may be prudent for investors to hold shares in oil stocks with sound financial backgrounds. One such company is Shell (LSE: RDSB), with it having a strong balance sheet and excellent cash flow. In fact, evidence of Shell’s financial strength can be seen in its acquisition of BG Group during the oil crisis. This indicates that Shell is very confident in its ability to survive a low-oil-price environment. And with it having a debt-to-equity ratio of just 41% even after the acquisition of BG, it seems capable of making further acquisitions in future.
Clearly, such a strategy is relatively risky. The price of oil could fall further and cause high quality assets to trade at even more appealing prices. However, Shell seems to be taking a long-term view on the price of oil, with it having the potential to rise due to increasing demand from the emerging world in future years. And with Shell cutting back on exploration and investment spending, it seems to be conserving cash where possible to ensure its survival even if the oil price undergoes a renewed fall in the coming months and years.
Of course, Shell remains a relatively volatile stock to own. Its profitability is highly dependent on the price of oil and so its share price could continue to trade within a wide range. However, this risk appears to be adequately priced-in to the company’s current valuation. For example, Shell trades on a forward price-to-earnings (P/E) ratio of just 12.8 and this indicates that it offers a wide margin of safety for long-term investors. And with Shell having a yield of 7.5%, which is due to be covered fully by earnings next year, it remains a sound income play too.
Coping with volatility
In terms of survival during the current oil crisis, Shell’s diversity, balance sheet strength and impressive cash flow mean that it’s likely to outlast the vast majority of its sector peers. This means that in the long run its position relative to industry rivals could improve, since Shell may be able to increase its market share and improve on its profitability. As such, while survival may be key for now, in the long term Shell seems to offer high potential returns for investors who can live with above average volatility.
Peter Stephens owns shares of Royal Dutch Shell. 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.