Why you should buy both the oil majors
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Is there really any difference between Shell and BP? To the investor, it seems the answer is a firm no. On the surface, BP looks rather better. Shell had a horrible 2004, announcing reserve cuts five times and only managing to replace 15%-25% of the reserves it used up. BP, on the other hand, replaced nearly 90% of the reserves it used up and announced this week that production rose 11% and profits 26% in 2004. Over the next two years, the firm anticipates returning more than £12bn to shareholders in the form of share buybacks and dividends.
So why then is Shell still trading at its usual 11% discount to BP, asks John Paul Rathbone on Breakingviews.com, just as it has been - give or take a few percent - for the last 40 years? The answer is simple. “Put on blinkers and BP’s advantages are less compelling. After all, both firms increased earnings by about a third last year. Both firms achieved similar returns on capital - about 20%. And both firms have promised monster payouts for the coming year and both “are giants that operate in a mature industry”. Note too that the palaver over Shell’s restating of reserves seems to be all but over. As The Sunday Times points out, “on Friday the market signalled that it would give Shell space to move on by responding calmly to the news of its fifth reserve cut”. Shell is also promising to reinvest £7bn or so of its revenues into “finding new oil resources”, and as such hopes to push reserve replacement up to 100% on average over the next few years.
The fact is that not only is there not really much to choose between the two oil majors, but the market values both on the basis of what it considers to be the likely long-term oil price. Short-term oil-price fluctuations don’t mean much unless they change the long-run forecast. Thus if either BP or Shell suffers a short-term triumph or disaster, the market treats the two more or less the same. The question then is not which is better, but are they both still a buy? After all, the oil price is no longer headline news and last hit a new high back in the autumn. My view is that they are still buys. Why? Because while CNN may have lost interest in talking about higher oil prices, the average price in the last quarter of 2004 was more than 50% higher than the year before. Higher oil prices look like they’re here to stay.
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One of the reasons that matters is that almost everyone has derisorily low official forecasts. BP still uses a $30-a-barrel guide to make its forecasts and many analysts are still sticking to their long-range $25 assumption. And bizarrely, most investors seem to think they’re right. BP and Shell have made back most of the ground they lost when their share prices fell in 2002, but there is little evidence they have yet adjusted for today’s oil price of $43, nor the dramatic improvement seen during 2004 to the medium-term profit outlook. In fact, Shell hasn’t traded on such a low p/e since the late 1980s when double-digit interest rates forced all equities into the cheap zone. Up until 2001, Shell’s earnings yield was always higher than the yield on gilts. Ten-year gilt yields are now 4.5%, suggesting Shell should be on a p/e of over 20 times (1/4.5 = 22 times) instead of its current 11.12 times.
Since last autumn, consensus analyst medium-term profit forecasts for BP are up around 43%. Yet technically speaking, BP has been in a downtrend now since the all-time high way back in 2000. This is even though analysts are 20% more bullish on BP’s profit outlook now than they were even at their most optimistic at the peak of the last cycle. Partly this is attributable to the slow recovery in blue-chip stocks this cycle, held back as they have been by regulation-enforced selling of equities by life companies and pension funds (the FTSE 250 has reached a new high, but the large cap FTSE 100 is still 27% below its 2000 high). But I think it is also partly down to the fact that the magnitude of the change in the consensus view has been so large and so fast that stock prices have struggled to keep up. I believe redressing this valuation discount will be a main feature of the market in 2005. That should mean that both the oil majors in the UK have a great year.
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