It's nearly impossible to predict the bottom of the cycle, but the worst of the declines for the energy sector seem to be behind us. With shares in Royal Dutch Shell (LSE: RDSB) more than a third lower than its peak in May 2014, investors may begin to think now could be the perfect time to buy back into its shares.
But although the oil price has made a strong recovery since mid-February, the medium-term outlook is less optimistic. Further gains in the oil price will likely be limited without more substantial cuts to global supply, which just do not seem likely given the failure of OPEC to reach an agreement on a production freeze.
What's worse, Shell's downstream profitability appears to have already peaked. In the first quarter of 2016, the company's downstream earnings fell by almost a quarter againstthe same period last year. Bigger refining margins have acted as a cushion against weak upstream profits, but this cushioning effect seems to be fast shrinking. And unless upstream earnings bounce back more strongly than analysts currently expect, Shell's earnings could yet have further to fall.
Today's share price sees the dividend currently yielding 7.6%. But with earnings cover set to fall below 0.5x this year -- ie, less than half of what is needed to fund its dividend, continued shareholder payouts at current levels no longer don't seem sustainable for much longer. The only way Shell can afford to maintain its payout without raising debt is to sell more assets. That's akin to selling the family silver, and could worsen future dividend security by hurting free cash flow generation in the longer term.
Better energy plays
Instead, investing in oilfield service stocks could be a better play on the energy sector. This is because although cuts in capital spending by oil producers have hurt the sector, rising global demand for energy is expected to drive continued growth in global oil and gas development in the longer term.
Petrofac (LSE: PFC) is a value play in the sector, with its shares trading at 9.3 times expected earnings this year. The company is also a less risky play, because its focus on the Middle East has spared it from the worst of the spending cuts. Relatively low production costs in the region meant investment levels have held up and Petrofac managed to lift its order book to record high of $20.7bn this year.
At a share price of 815p, Petrofac's dividend yield stands at 5.7%. That's lower than Shell's yield but, unlike the oil major, Petrofac's dividend is well covered. Earnings this year are expected to cover its dividend 1.9 times, which suggests not only that the dividend is secure, but that there may also be opportunity for an increase in shareholder payouts this year.
An alternative play on the sector is Plexus Holdings(LSE: POS). The firm has seen the value of its shares drop by almost two-thirds over the past year, but its longer term fundamentals seem attractive. The Aberdeen-based firm owns an innovative proprietary well-head system that is more reliable and requires less maintenance than the type its competitors use. This gives it a competitive advantage and allows it to generate much wider operating margins than the industry average.
The company is worth a closer look for investors that are willing to tolerate a little more risk.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Petrofac. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.