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Why I’m expecting Royal Dutch Shell plc and BP plc to plummet!

Investor appetite for the oil segment has taken a knock in recent weeks as fears of a prolonged supply glut have weighed.

British majors Royal Dutch Shell (LSE: RDSB) and BP (LSE: BP) have seen their share prices slip 10% and 7% respectively during the past six weeks, for example. And I believe a sharper retracement could be just around the corner.

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Stocks keep surging

Broker predictions that the oil market is set to balance later this year are being put under increased scrutiny as already-plentiful stockpiles continue to build.

The US Energy Information Administration advised on Wednesday that the country’s inventories sucked in a further 2.3m barrels of crude over the past week, taking the total to 525.1m barrels and once again confounding analyst predictions — a more modest 1.1m-barrel build had been anticipated.

Putin speaks

On the plus side, the market remains hopeful of a much-needed supply freeze from OPEC and Russia to boost Brent prices. And Vladimir Putin gave these hopes a shot in the arm on Friday when he told Bloomberg that “it would be correct to find some sort of compromise.”

But critically Putin cast doubts on Iranian participation as the country repairs the damage caused by years of sanctions by steadily raising its own output. Tehran’s reluctance to turn down its own pumps is likely to put paid to any deal.

A production cut touted by Saudi Arabia, Qatar, Venezuela and Russia earlier this year failed to materialise as the faultlines across the Middle Eastern bloc became increasingly apparent. Besides, production from both OPEC and Russia has hit record levels in the months following these initial rumours, scotching rhetoric pointing towards a potential accord.

And a steady rise in the US rig count further undermines hopes of a tough rebalancing act being successful — Baker Hughes data has shown rig numbers rise during eight of the past nine weeks.

Rotten value

I believe that investors are still failing to fully consider these factors, particularly when you look at Shell and BP’s gargantuan earnings multiples.

Conventional wisdom suggests that a reading of 10 times or below is fair value for stocks with uncertain earnings outlooks and/or high risk profiles. Yet for 2016, BP changes hands on a ratio of 31.8 times. And Royal Dutch Shell deals on an even-worse reading of 25.7 times.

Of course many investors are prepared to suck up hefty near-term earnings multiples in exchange for the promise of stunning bottom-line growth over a longer time horizon.

But neither Shell nor BP can offer these guarantees, in my opinion. Both companies continue to reduce capex budgets, slash jobs and jettison ambitious projects like Shell’s Alaskan drilling venture to shore up their balance sheets and ride out the current oil price storm.

And the swinging momentum away from ‘dirty’ fuels such as oil and towards alternative methods like wind and solar provide further roadblocks to growth for the fossil fuel majors in the coming years.

I expect earnings, and with it the stock prices of BP and Shell, to come under increasing pressure in the immediate future and beyond.

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Royston Wild has no position in any shares mentioned. 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.

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