After gains of more than 40%, is it too late to buy these 2 Footsie oil giants?

2016 was a great year for shareholders of Royal Dutch Shell (LSE: RDSB) and BP (LSE: BP). They say elephants don’t gallop, but during 2016 these two oil majors proved their critics wrong by rallying from near 10-year lows and outpacing the rest of the market.

Even though at the beginning of 2016 many City analysts had written off BP and Shell, predicting that the shares would languish for many years to come, throughout the year the companies defied expectations. 

Shares in these two multibillion-dollar oil giants rallied by 46% and 68% respectively excluding dividends in 2016. 

Will the rally continue? 

Thanks to OPEC’s supply agreement, investor sentiment towards BP and Shell has improved dramatically over the past 12 months, but the big question is, have the shares run out of steam?

The fortunes of BP and Shell are closely linked to the price of oil and over the past year the shares of these oil majors have rallied as the price of oil has moved from around $35 a barrel to nearly $60. Still, even after this rally, the price of oil remains more than 50% below its 2014 high. 

It all depends on oil

If the price of oil can return to $70, $90 or even $100 a barrel, then the shares of BP and Shell have much further to go. Over the past two years, managements at BP and Shell have been aggressively cutting costs to rebase the business to the new normal of lower oil prices. These cost cuts have been designed to make the two profitable with oil trading in a range of $50 to $60. If the price returns to $100, then profits will surge thanks to the new lower cost base for both companies.

Shell will most likely generate the best returns for investors in this scenario. The company dramatically increased its production when it acquired BG Group near the height of the oil downturn. Initially, the deal was heavily criticised by City analysts and shareholders alike. But as oil prices move higher, Shell’s extra production, coupled with its lower cost base will prove to the market that management was correct to do this deal when it did.

On the other hand, BP hasn’t conducted any transformational deals over the past two years, so it’s likely that the upside for the company’s shares is more limited than that of Shell. Still, BP remains one of the FTSE 100’s dividend champions, and higher oil prices will give the group scope to increase the payout. Shares in BP currently support a highly attractive dividend yield of 6.4%. Shares in Shell yield 6.5%.

The bottom line 

So overall, even after racking up capital gains of over 40% during the past 12 months, shares in BP and Shell look like they have further to run. Shares in Shell are likely to have more upside than those of BP thanks to the group’s increased production profile.

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Rupert Hargreaves owns shares of Royal Dutch Shell B. 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.