How To Invest In Oil: Consider Royal Dutch Shell

| About: Royal Dutch (RDS.A)

Summary

Oil prices have continued to fall sharply reaching a 12-year low on January 20, and it is not clear if the 19% rise in Brent crude oil indicates a bottom.

Oil price will eventually recover. However, investing directly in oil by future contracts will cause part or all the profit from price appreciation to be lost due to contango conditions.

Investing in a supermajor integrated oil & gas company like Royal Dutch Shell will give investors a significant price appreciation when oil prices recover, along very generous dividend yielding 8.4%.

Shell has a strong balance sheet, and it has been able to generate a positive free cash flow in 2015 of $0.9 billion.

Despite the extremely low oil price in the fourth quarter, Shell's upstream operations have shown earnings of $0.5 billion.

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Oil prices have continued to fall sharply reaching a 12-year low on January 20, and it is not clear if the 19% rise in Brent crude oil and 10.2% increase of WTI crude oil since then indicates a bottom. However, oil price will eventually recover sooner or later. As no one has anticipated crude oil plunging 70% in a year and a half, it is impossible at this moment to determine when oil prices start to climb. However, we can try to get some conclusions from the previous crash in oil prices due to the global financial crisis in 2008. WTI crude fell 63.1% in less than eight months from an all-time record of $143.28 a barrel on July 03, 2008, to $52.90 on February 19, 2009. However, after one year, on July 02, 2009, WTI price climbed 40.8% from February bottom, and after three years, on July 01, 2011, the oil price was 79.5% up from 2009 bottom, as shown in the table and charts below. Of course, current global economic conditions are different (for the better), and the same pattern has not been repeated. However, commodities prices are moving in cycles, and lower capital expenditures on exploration and production will eventually cause oil prices to rebound.

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WTI Crude Oil, Monthly Chart Since 2004

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WTI Crude Oil, April 2016 Leading Contract Daily Chart

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Brent Crude Oil, April 2016 Leading Contract Daily Chart

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Charts: TradeStation Group, Inc.

As such, what is the best way to invest in oil? Investing directly in oil by buying future contracts creates a certain problem. WTI crude oil futures are currently in contango; prices of future contracts for distant periods are higher than for those for the near future. in the contango condition, before the expiration of the contract, it is necessary to roll over to a more expensive contract for a further expiration month. In this case, part or all the profit from price appreciation is lost. The table below shows CME WTI crude oil futures quotes from March 2016 to March 2017. The March 2017 quote of $41.55 per barrel is 34% higher than the March 2016 price of $31. Thus, an investor in future contracts of oil will not take advantage of the full rise in the price of oil if it occurs this year. Also, commissions and the trading expenses will cut some of the gains from oil price appreciation.

Source: CME WTI Crude Oil Futures Quotes

On the other hand, investing in a supermajor integrated oil & gas company like Royal Dutch Shell (NYSE:RDS.A), (NYSE:RDS.B), will give investors a significant price appreciation when oil prices recover, along very generous dividend yielding about 8.4%. Shell has confirmed its intention to pay a dividend of at least $1.88 per A share in 2016, currently yielding 8.42% (each ADS represents two ordinary shares, two A Shares in the case of RDS.A). In my view, this high dividend pay is sustainable. The company has a long record of continued raising its dividend. The annual rate of dividend growth over the past three years was at 3.8%, over the past five years was at 2.3%, and over the last ten years was at 7.8%. Even during the global economic crisis of the years 2008-2009, the company continued to raise its dividend. As such, it is hard to believe that Shell would break that many years' tradition. Moreover, Shell has a strong balance sheet, and it generates free cash flows. The company had $31.75 billion in cash and short-term investments at the end of the fourth quarter and $58.38 billion in total debt. The total debt-to-equity ratio is pretty low at 0.36. The full year 2015 cash flow from operating activities was $29.8 billion, compared with $45.0 billion in 2014. The full year 2015 capital investment was $28.9 billion, $8.4 billion lower than in 2014. This was delivered by efficiency improvements and more selectivity on new investments. It is worth noting that in contrast to many other integrated oil & gas companies, Shell has been able to generate a positive free cash flow in 2015 of $0.9 billion. Also, despite the extremely low oil price in the fourth quarter, Shell's upstream operations have shown earnings of $0.5 billion.

RDS.A Dividend Chart

RDS.A Dividend data by YCharts

On February, 04, Shell reported its fourth-quarter and full-year 2015 unaudited results which missed EPS expectations by a $0.02 (3.3%). The company reported fourth-quarter net income of $939 million. Net income was $0.30 per share, earnings, adjusted for non-recurring costs, were at $0.58 per share.

Source: Fourth quarter presentation

In the report, Royal Dutch Shell Chief Executive Officer Ben van Beurden commented:

The completion of the BG transaction, which we are expecting in a matter of weeks, marks the start of a new chapter in Shell, rejuvenating the company, and improving shareholder returns. We are making substantial changes in the company, reorganising our Upstream, and reducing costs and capital investment, as we refocus Shell, and respond to lower oil prices. As we have previously indicated, this will include a reduction of some 10,000 staff and direct contractor positions in 2015-16 across both companies.

In 2015, we significantly curtailed spending by reducing the number of new investment decisions and designing lower-cost development solutions. For 2016, we have exited the Bab sour gas project in Abu Dhabi, and are postponing final investment decisions on LNG Canada and Bonga South West in deep water Nigeria. Operating costs and capital investment have been reduced by a total of $12.5 billion as compared to 2014, and we expect further reductions in 2016.

As a result of our actions in 2015, we have retained a strong balance sheet position, with 14% gearing. Shell will take further impactful decisions to manage through the oil price downturn, should conditions warrant that. Shell's dividends for 2015 were $1.88 per share, and are expected to be at least $1.88 per share in 2016, as previously announced.

Valuation

Since the beginning of the year, RDS.A's stock is down 2.4% while the S&P 500 Index has decreased 8.0%, and the Nasdaq Composite Index has lost 12.9%. However, since the beginning of 2015, RDS.A's stock has lost 33.3%. In this period, the S&P 500 Index has decreased 8.7% and the Nasdaq Composite Index has dropped 7.9%.

RDS.A Daily Chart

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Chart: TradeStation Group, Inc.

RDS.A stock is trading below book value; price to book is at 0.88, and its price to sales ratio is very low at 0.48. The forward P/E is very low at 13.14, and the Enterprise Value/EBITDA ratio is also very low at 6.33. In addition, its PEG ratio (Price/Earnings to Next Year Growth Rate) is very low at 0.39, the third lowest among all energy companies with market cap greater than $20 billion, as shown in the table below.

Source: Portfolio123

Summary

Oil prices have continued to fall sharply reaching a 12-year low on January 20, and it is not clear if the 19% rise in Brent crude oil and 10.2% increase of WTI crude oil since then indicates a bottom. However, oil price will eventually recover sooner or later. Investing directly in oil by buying future contracts creates a certain problem. WTI crude oil futures are currently in contango. Therefore, before the expiration of the contract, it is necessary to roll over to a more expensive contract for a further expiration month. In this case, part or all the profit from price appreciation is lost. On the other hand, investing in a supermajor integrated oil & gas company like Royal Dutch Shell will give investors a significant price appreciation when oil prices recover along very generous dividend yielding about 8.4%. Moreover, Shell has confirmed its intention to pay a dividend of at least $1.88 per A share in 2016. The company has a strong balance sheet, and it has been able to generate a positive free cash flow in 2015 of $0.9 billion. Also, despite the extremely low oil price in the fourth quarter, Shell's upstream operations have shown earnings of $0.5 billion. All these factors bring me to the conclusion that Shell's stock is a smart long-term investment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.