Shell (LSE: RDSB) is a stock with considerable total return potential. Certainly, the price of oil has been hugely volatile in recent years, but with OPEC cutting supply, and demand continuing to grow, it could perform well in the long run.
Since Shell has a diverse business, it may offer reduced risk compared to rivals such as Tullow Oil (LSE: TLW). Furthermore, the company’s income prospects mean that it could be worth buying and holding for the long term.
Oil price potential
While OPEC’s production cut is only due to last until the end of May, there’s a good chance it will be extended beyond that date. After all, it has reduced the pressure on the cartel and provided improving profitability as the price of oil has risen.
Similarly, demand for oil could rise in future years. It’s set to remain a key part of the energy mix across the developing world in particular and oil is likely to be the dominant means of fuelling transport across the emerging world for the next couple of decades. The gas price could also rise due to its cost efficiency and the fact it’s a cleaner alternative to other fossil fuels such as coal. This could lead to rising demand and mean that while the price of oil is currently low, it may move higher and boost the profitability of Shell, Tullow Oil and their peers over a sustained period.
Diversity and financial strength
Shell’s asset base is well diversified, especially since it purchased BG Group. This means that it offers a lower risk profile than sector peers such as Tullow Oil. If there are challenges in one region of the world then they can be more easily offset by improved performance elsewhere.
Of course, if the price of oil and gas falls, Shell will see its profitability come under pressure. However, it has a modestly leveraged balance sheet as well as exceptionally strong cash flow. This should mean it’s better able to take advantage of lower oil prices through acquisitions, while also having a better chance of survival should the oil price decline. Given the uncertainty present in the oil and gas industry, this financial strength could prove to be a major asset in the long run.
Shell currently yields 6.4% from a dividend which is expected to be covered 1.3 times by profit next year. This means its dividends are not only highly attractive, but also sustainable at their current level. This compares favourably to many other oil and gas companies. For example, Tullow Oil isn’t due to pay a dividend in the 2017 financial year.
With inflation forecast to rise during the course of the year, high and sustainable dividends could become increasingly popular over the medium term. As such, Shell could see demand for its shares rise, which could compress its yield and push its share price higher. Alongside its diversity and the positive outlook for oil, it appears to be a sound stock to buy and hold for the long term.
Clearly, Tullow Oil is also attractive due to its rising production and sound strategy, but Shell remains the more obvious choice based on the risk/reward ratio.
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Peter Stephens owns shares of Royal Dutch Shell B. 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.