The Sunday Telegraph: The outlook for Britain’s two oil majors

Edited by David Litterick
Last Updated: 12:33am GMT 10/02/2008

BP
Price 536p
Questor says Buy

Between them, Royal Dutch Shell and its arch-rival BP have garnered some pretty negative headlines over the past few years.
  
For Shell, there was the 2004 reserves scandal, when it admitted to booking reserves that it didn’t actually have. The lawsuits still rumble on.

For BP, it was the Texas City explosion, the Prudhoe Bay oil spill and the accusations of market rigging that dragged the company through the mud and left its reputation in tatters. There too, the company lawyers rarely complain about a shortage of work.

Nevertheless, Britain’s two great oil majors have battled hard to put their problems behind them. The past two weeks have given some indication as to their relative success.

Two weeks ago, Royal Dutch Shell reported the biggest annual profit in UK corporate history. A week later, BP posted a disappointing 22 per cent fall in its earnings. On the basis of the headlines alone, it would appear that Shell has done better in laying its ghosts to rest. That would be the indication from the share price too. While BP outperformed the FTSE All Share by 7 per cent last year, Shell did far better, outperforming by 14 per cent.

The detail tells a different story. Shell’s fourth quarter profits may have been impressive to the uninitiated, but the figures came in below expectations. After seven quarters of comfortably beating analysts’ expectations, that was a clear disappointment.

With oil still hovering just under the $100 a barrel level, oil companies should be laughing all the way to the bank. Refining margins may be wafer thin, with profits from the filling station forecourts almost non-existent, but the upstream operations – getting the stuff out of the ground and selling it on – should be enjoying bumper days. The problem of course is that the simple act of getting it out of the ground is getting far less simple by the day. Even finding new reserves of the stuff is harder, as all the easy-to-locate and drill oil is running out. The cost of drilling the rest is rising fast.

Shell last week refused to release figures showing the rate it is replacing reserves that it has exhausted – something that continues to concern the City – despite increasing its capital expenditure programme from $13bn (£6.6bn) to £27bn over the past four years. Doubts linger over whether this increase will result in improved production levels. Investors will have to wait until the company’s strategic update in May to hear the answers to their questions.

BP’s results disappointed too, and the company was quick to manage expectations about the tough challenges ahead, but there was some good news for shareholders. After years in which the company has preferred to return money through share buybacks, it yesterday switched tack in favour of increased dividends. An increase in capex from $18bn last year to $22bn this year as it plays catch-up with Shell should also see some of the stock’s underperformance reversed.

At these times, talk inevitably turns to the likelihood – or otherwise – of a merger between the two. Certainly, such a deal looks more like being a merger of equals further down the line, but the regulatory and operational barriers to that make it unlikely.

The entire sector has been de-rated in recent months and valuations now stand at close to a 10-year low with both Shell and BP trading on price-earnings ratios that hover around nine times. Many, Questor included, believe that is too low. But for investors who want exposure to just one of the oil majors should look at BP’s 5 per cent prospective yield, against Shell’s 4.1 per cent, and at BP’s greater upside potential. Questor prefers BP.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/02/10/cxquest110.xml

This website and sisters royaldutchshellgroup.com, shellnazihistory.com, royaldutchshell.website, johndonovan.website, and shellnews.net, are owned by John Donovan. There is also a Wikipedia segment.