While the oil price has risen from a low of under $30 per barrel to above $50 per barrel in 2016, there’s no guarantee that this trend will continue. Investors should therefore seek out oil stocks with wide margins of safety in order to minimise downside risk.
Of course, a wide margin of safety provides greater potential rewards should the price of oil move higher. And by focusing on this, investors can deduce whether Shell (LSE: RDSB), BP (LSE: BP) or Tullow Oil (LSE: TLW) has the best prospects to rise by 30%-plus.
It’s an exciting time for Tullow Oil. Its production is in the process of being ramped up due to its offshore Ghana TEN assets coming onstream. This is set to shift the investment profile of Tullow Oil somewhat, with it signifying a change from a predominantly exploration company to one focused on production to a greater extent.
The result of this is due to be significantly improved profitability and cash flow. For example, Tullow Oil is forecast to increase its bottom line by 142% in the 2017 financial year. This puts it on a price-to-earnings growth (PEG) ratio of 0.1, which indicates that it has a wide margin of safety. This could stimulate investor sentiment in the stock and push it higher by considerably more than 30%, while also improving Tullow Oil’s long-term sustainability by making its sizeable debt repayments more affordable.
BP offers a somewhat different appeal to Tullow Oil. It’s not expected to ramp up production to the same extent as its sector peer, but it’s in a transitional period. BP is now moving away from the Deepwater Horizon oil spill of six years ago and its financial performance should benefit due to the reduced compensation payouts likely to be required in future years. This should aid the company’s dividend, with BP already yielding a hugely enticing 6.9% at the present time.
BP’s dividend is due to be fully covered by profit next year. This indicates that while dividends may not increase rapidly, they’re likely to be affordable over the medium-to-long term. And even if BP rises by 30%, its shares would still yield 5.3%. This provides evidence of their upside potential and wide margin of safety since a yield of 5.3% would be around 180 basis points higher than the FTSE 100’s yield.
While Tullow Oil and BP have wide margins of safety and the potential to rise by over 30%, Shell offers the best risk/reward opportunity of the three stocks. That’s because its bottom line is expected to benefit over the coming years from the integration of the BG asset base, with Shell recently increasing the amount of anticipated synergies from the combination. This could positively catalyse investor sentiment in Shell and push its shares upwards by over 30%, while its dividend yield of 7% beats BP’s and provides evidence of Shell’s exceptionally wide margin of safety.
Unlike BP, Shell isn’t recovering from a major oil spill and its balance sheet and diversity is more appealing than for Tullow Oil. Shell’s dividend is due to be fully covered by profit next year and because of its lower risk and high potential rewards, it’s the pick of the three oil majors and the one which is likely to deliver a 30%-plus return first.
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Peter Stephens owns shares of BP and Royal Dutch Shell. The Motley Fool UK has recommended BP and 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.