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Why I think Royal Dutch Shell plc should be dealing 33% lower

Signs that the oil market’s enduring material surplus may take longer to erode than hoped-for following OPEC’s landmark output freeze in November have seen Royal Dutch Shell (LSE: RDSB) retreat from January’s highs around £23.80 per share.

Indeed, the energy giant is now dealing 8% lower to those three-year peaks. But I believe the company’s share price should still be dealing much, much lower.

The City expects earnings at Shell to explode 93% in 2017, resulting in a P/E ratio of 15.2 times. But I reckon expectations of such an electrifying rise remain on very shaky ground, given that a healthy uptick in barrel values is needed to make these forecasts a reality.

I believe a forward P/E ratio of 10 times, anchored on the watermark reflective of stocks with high risk profiles, is a fairer reflection of Shell’s bottom-line prospects.

And a subsequent share price re-rating would leave the crude colossus dealing at £14.37 per share, representing a stunning 33% discount to current levels

Supply Swells

Investor sentiment has been influenced by a relentless rise in the US rig count since late last year, with recent Baker Hughes numbers showing the number of units hitting fresh 16-month peaks last week, at 597.

But exploding output in the States is not the only barrier to Shell’s earnings recovery as production levels leap elsewhere.

In Brazil, for instance, state-owned producer Petrobras pulled a record 2.3m barrels of the black stuff out of the ground on average in December, taking out the previous record of three months earlier. Although production stepped back last month due to scheduled maintenance, average pre-salt production hit an all-time peak of 1.34m barrels per day.

Investment in Canada’s fossil fuel industry is also driving output here to the stars. Indeed, latest export numbers from the National Energy Board showed crude exports averaged 538,089 cubic metres per day in November, surging from 485,863 metres in the prior month.

Data from Baker Hughes last week also showed that 194 oil rigs were churning material out of the ground last week, almost double the number of units seen a year ago and suggesting that production levels should keep on climbing.

Risky Business

Oil prices received a fillip on Tuesday after OPEC Secretary General Mohammed Barkindo said the group is aiming to keep the compliance rate on an upward bent. The cartel saw conformity with autumn’s agreed production quota hit an impressive 90% last month.

But whether or not the group can keep the rate rising in the months ahead, the viability of November’s deal lasting beyond the summer deadline will be hotly contested by many members seeking to ramp up their own production.

A failure to extend the accord could prove catastrophic for oil prices as rising production elsewhere already threatens to keep global crude inventories at bursting point. US stockpiles struck a fresh record of 518m barrels last week, and are broadly expected to hit new highs when the EIA reports again this week.

Clearly claims of a balanced oil market remain very much in the air, and with it a meaty earnings bounce at the likes of Shell. Given the murky supply and demand indicators still washing over the energy sector, I believe investment in the oil major is still extremely risky at present, and particularly at current share prices.

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Royston Wild has no position in any shares mentioned. 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.