How weakness for Shell or BP could tip the Footsie scales

What will determine the direction of UK equities in the second half of the year? The outlook for interest rates and inflation, for sure. One could also add the trajectory of economic growth to the list.

But what about oil? If the price of crude keeps falling – it dropped 11 per cent last week to close below $60 a barrel for the first time since mid-May – what are the implications for the stock market?

Potentially they could be very troubling. Aside from the fact that further weakness would probably signal a prolonged global recession, it would also hit UK investors in the pocket. The oil and gas sector is expected to generate more than a quarter – or £14.6bn – of the £55bn in dividends expected to be paid out by constituents of the FTSE All-Share index this year. BP alone is expected to contribute £6.7bn to its investors.

Analysts estimate that BP, which is also the UK’s biggest listed company, and Shell need an oil price of between $60-$65 barrel to be able to pay for their dividends and their multi-billion dollar capital spending programmes from cash flow. And given the difficulty these large integrated oil companies face in replacing production and maintaining reserves, they are more likely to cut the dividend than skimp on exploration. Last year, for example, Shell’s reserve replacement ratio was 97 per cent, the seventh time in the past nine years that the company has failed to replace the volume of oil it produced.

Oil and gas companies also have a large stock market weighting; they account for almost a fifth of the FTSE All-Share index. Indeed, the London market’s recent weakness is in large due to the performance of its three big oil stocks. Since Brent crude reached $71.79 on June 11, the FTSE 100 has fallen 7.4 per cent, with BG down 14 per cent, BP 12 per cent and Shell 14.5 per cent.

However, it would be a mistake to be too pessimistic on the oil price just yet. Given the mixed economic data and the rapid rise from a February low of $43.41, many analysts expected Brent to retrench. “We sense that the rapid oil price pull back closer to $60 per barrel sets a more sustainable level that is more closely tuned in to the fundamentals of the oil market,” says Cazenove.

Moreover, a falling oil price does not necessarily translate into a dividend cut. Given their strong balance sheets, the large oil companies can part fund their dividends by an increase in debt. They can also cut costs, something that has been a feature of Tony Hayward’s stewardship at BP. Deutsche Bank estimates that BP’s operating costs will be at least $2bn below those of the previous year.

And if BP, which reports results at the end of the month, and Shell are able to hold their dividends, Cazenove’s Fred Lucas says their shares could benefit, particularly if investors adopt a more defensive stance as they await confirmation that an economic reco- very is under way. “Sector valuations [for big oil] are low – we measure a 2009 sector average price earnings ratio of 8 and dividend yield of 6 per cent,” he notes. Of course, there are many other companies in the oil and gas sector. They may be nowhere near as big as BP or Shell but have interesting exploration programmes that can make a material difference to their share prices. Analysts reckon the prospect that Tullow Oil is drilling in Uganda could add £1.3bn to its market value.

Indeed, there has been a flurry of corporate activity among these so-called exploration and production companies (E&P) in 2009. Heritage Oil is merging with Turkey’s Genel Energy and Addax Petroleum is set to be acquired by China’s Sinopec for $7.4bn. Further deals are expected given China’s thirst for energy. Emerald Energy is tipped as a target for a Chinese company, while Centrica must decide by Monday evening whether to bid for Venture Production or walk away.

Unfortunately, the E&P companies do not have the muscle to shift the index. BP, Shell, and, to a lesser extent, BG do. Because of their size and sensitivity to the crude price, investors should be watching the oil market as closely as they are key economic data and the outlook for interest rates and inflation.

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