The oil and gas industry has been a tough place to invest in recent years. Practically all companies within the sector endured a hugely challenging period when the oil price declined. It slumped from around $115 per barrel to under $30 per barrel. This caused severe financial difficulties across the sector and Shell‘s (LSE: RDSB) share price declined by as much as 46% from peak to trough.
However, the company was able to not only survive, but also strengthen its position relative to its peers. This could indicate a wide economic moat which may mean it has a bright decade ahead of it.
Opportunity
While a number of oil and gas companies’ thoughts immediately turned to survival when the oil price declined, Shell seemed to take a long-term view. Certainly, it made changes to its business model in order to survive. For example, it cut capital expenditure and exploration costs in order to shore up its income statement. It also managed investors’ expectations by assuming a lower oil price would be set to stay. However, it also made plans for a rising oil price, which may set it up for fast earnings growth in future years.
For example, Shell viewed lower oil prices as an opportunity. It purchased BG Group’s assets at what may prove to be a hugely attractive price, since it had the potential to improve the company’s long-term outlook. Although the oil price subsequently moved lower than when Shell struck the deal to buy BG, the company went ahead with the acquisition since it maintained a bullish view on the oil price in the long run.
Favourable position
Shell was able to take a long-term view on the oil price because of its financial strength. Compared to other oil companies, it has a sound balance sheet and strong cash flow. It has not sought to leverage up its balance sheet to its maximum level in order to grow rapidly, but rather has taken a more measured and conservative approach. While this inevitably means returns will be lower in the boom years, it also means that Shell has a competitive advantage over its peers during leaner years for the industry.
Looking ahead, the future direction of the oil price is hugely uncertain. OPEC could end the production cut mid-way through the year, or could decide to extend it until the end of the year. Similarly, demand from the emerging world and developed world could prove to be sluggish, as it has in the recent past. Or it could pick up based on President Trump’s potentially pro-fossil fuel policies and renewed demand from China.
Either way, Shell seems to be in a favourable position relative to its rivals. If the oil price rises, its acquisition of BG could push earnings and cash flow significantly higher. Likewise, if the oil price falls, Shell could take advantage of lower valuations through M&A activity. Therefore, it seems to offer the most attractive risk/reward ratio within the large-cap oil and gas sector, which could make it a stock worth holding for the long run.
