Shell and BP shrink under the analysts’ spotlight

BP and Royal Dutch Shell, Europe’s largest oil companies by market value, will not perform as well as some of their European rivals and may have to cut their dividends because crude oil prices have fallen to around $40 a barrel, a leading UK brokerage has warned investors.

Europe’s large-capitalisation oil stocks are trading near all-time highs compared with 2009 earnings forecasts and are not priced to be “defensive,” Barclays Capital analysts, led by Tim Whittaker and Lucy Haskins, said in a note to investors. They have assigned “underweight” ratings to London-based BP and Shell, which operates out of the Dutch city of The Hague.

Total, based in Paris, and Rome-based Eni have more defensive earnings and cash flows, the analysts said, rating them “overweight”. They also recommended buying Madrid-based Repsol YPF, saying the shares are trading “at the bottom of their historical discount range”.

Barclays’ assessment of BP and Shell is at odds with a more positive view taken by Cazenove.

The venerable investment house has repeated its “outperform” view on BP and Shell, saying the market has not understood the value of the two group’s dividend yield in a world where many companies are cutting pay-outs.

With the price of oil stabilising at around $40 a barrel, Cazenove believes BP’s dividend is safe; in any case, the broker anticipates the price of oil will rally to around $80 a barrel by 2011.

BP and Shell also have the option of borrowing to finance their dividend payments until times get better again.

“We also believe that BP can borrow to pay its dividend, as can Shell for two years before capital expenditure and cost reductions become more of a necessity,”

Cazenove added.

Investors have flocked to large oil companies because they have strong balance sheets and their dividends are considered safe, Whittaker and Haskins said in the note.

This leaves them with price- earnings multiples that are twice their historical average, the analysts said. Barclays forecasts that oil prices, down nearly 60% from a year ago, will not rise significantly for the next two years, even though the industry’s costs have doubled since 2004.

“The consensus market view appears to be that the oil price will quickly recover, but our analysis, based on our incremental supply model, suggests it won’t tighten until 2012,” Whittaker and Haskins said.

Spokesmen for BP and Shell said both companies had noted the Barclays’ rating but would make no other comment.

BP will present its develop- ment strategy tomorrow. Earlier this month, the group reported a record annual profit for last year.

Replacement cost profit was $25.6bn (£17.6bn) in 2008, up 39% from the $18.4m it reported a year earlier. However, the bulk of the profits were earned at the start of last year, when crude prices were surging.

BP’s performance was much weaker towards the end of last year after a precipitous slide in the price of oil during the autumn. The price of a barrel of oil has fallen by more than $100 from the high of $147 per barrel registered in July last year.

The company is continuing its search for a new chairman to replace Peter Sutherland after the with- drawal from the race of Paul Skinner, Rio Tinto’s chairman.

Anna Mann, the headhunter who is leading the search, has been drawing up a new list of candidates for the position, including executives based in the UK and Europe.

BP earnings will fall to $8.3bn in 2009, a level last seen in 2002, the Barclays analysts said. The company is more vulnerable to the industry downturn than peers, and “balance sheet pressures may constrain near-term investments,” Whittaker and Haskins said in their note.

In January, Royal Dutch Shell reported that it had suffered a sharp decline in profits in the fourth quarter because of the fall in the oil price, but it has still recorded the largest annual profit for a European company. It has also committed to maintaining its capital spending programme this year – one of the largest in the world – at close to last year’s level, in spite of the weaker outlook for oil and gas demand and prices.

Net earnings on a “current cost of supply” basis, adjusting for the effect of price changes on inventories, were $4.8bn in the fourth quarter, down 28% from $6.7bn in the equivalent period of 2007.

The underlying profit, excluding one-off items, was slightly below analysts’ consensus expectations.

Full-year post-tax profits for 2008 were $31.4bn, up 14% from $27.6bn, the previous European record, in 2007. The dividend for the first quarter of 2009 will be rise 5% to 42 cents, compared with an 11% increase in 2008.

The main reason for the drop in profits in the fourth quarter was the fall in the oil price, which averaged $57.60 a barrel, compared with about $111 in the third quarter and $83 in the fourth quarter of 2007.

That was offset by a slight rise in the average price at which Shell sold its gas, because of a rise in European prices, which are poised to fall sharply this year because they are set by long-term contracts linked to oil prices with a six to nine-month lag.

Total production, which is split about equally between oil and gas, was down 2%, the sixth successive year of falling production.

However, Shell said that stripping out effects such as output cuts from Opec countries, hurricanes and divestments, underlying production was unchanged from 2007.

Profits in the fourth quarter from the exploration and production business, the largest part of the group, fell 24% over the year to $3.7bn, although that was flattered by one-off items. The underlying drop was about 40%.

While Shell’s stock has out- performed the wider market by about 17% since July 2008, it will be hard-pressed to cut spending over the next year, Whittaker and Haskins said. “We think Shell will have a harder time than most,” they added.

Barclays sees brighter prospects for Repsol, mainly due to its investment in Brazil.

The huge South American country has a booming oil industry and discovered considerable reserve of oil and gas offshore in the South Atlantic.

Total will benefit from resilient cash flows, lower-than-average costs and greater financial flexibility, the analysts said. Eni’s gas business gives it a competitive advantage, according to Whittaker and Haskins.

With no domestic production but deep roots in the Middle East and Africa, Total – as well as its long-time domestic rival Elf Aquitaine, which it acquired in 2000 – has always been forced to blaze its way through faraway lands.

It has struck deals in countries where few wished to do business, like Sudan and Burma, or sailed against the tide when it saw lucrative opportunities, as it did in Iran in the 1990s. Such forays have come with complications: in separate investigations, French judges have been examining Total’s role in the United Nations oil-for-food programme in Iraq, and whether it made secret payments to enter the Iranian market.

Total’s appetite for risk has also turned it into the top-ranked western oil company in Africa, and the second-largest in the Middle East, after Exxon.

Total pumps an average of 2.3 million barrels of oil and gas a day, and it earned more than $15bn last year.

Although the company has operations throughout the Middle East, some of its biggest bets in the region have not yet paid off.

During the 1990s, Total nego- tiated with the government of Saddam Hussein and laid the ground- work to eventually develop Iraqi oil fields.

But now, some Iraqi officials prefer US companies to European ones and view Total with suspicion because of this past. In Iran, a political confrontation with the West has forced a reluctant Total to walk away – at least for now – from a multi- billion-dollar investment to develop a huge natural gas field there.

However, Total still has several other targets. It is aggressively developing assets around the world, whether in deep offshore sites in Angola and the North Sea, or onshore in the Sahara in Libya or in Venezuela’s forests.

The firm has also decided that part of its future lies in developing expertise in nuclear energy.