With the price of Brent crude oil holding above $50 a barrel, which is the best oil stock to own?
Shell's (LSE: RDSB) scale and diversification gives investors greater confidence in the company's financial stability and its ability to generate profits throughout the commodities cycle. Its vertically integrated business model has sheltered the company from the worst of the decline in oil prices, with strong earnings from its downstream refinery operations softening the blow to overall profitability and free cash flow generation.
But while the impact of lower oil prices has been softened, net adjusted earnings per share in the first quarter of 2016 still fell by 63%. Free cash flow remains stuck in negative territory, and its entire dividend and a significant proportion of capex is being funded by debt and asset sales.
Shell's finance chief has said he will do "whatever it takes to balance the cash flow through the cycles". But that would likely come at a huge cost. Cutting investment and selling assets will balance the books in the short term, but longer term it would hold back future profits, which dividends in later years will depend upon. As a sign of trouble ahead, Shell's dividend futures are pricing in a cut of 42% for its 2017 dividend.
While oil majors rushing to hit a $60 break-even target, many smaller oil producers have substantially lower average break-even costs. Cairn Energy(LSE: CNE) is one such exploration and production (E&P) company positioned for a low oil price world.
Cairn has so far focused on exploration rather than production, but that could soon change with the company rapidly developing its oil resources. Its two major North Sea oilfields, Catcher and Kraken, are expected to begin production in 2017 and have an estimated weighted production cost of $17 a barrel, well below today's $50+ market price. Moreover, the company is cash rich, with net cash of $603m, enough to cover its capital spending and exploration plans until at least 2017.
But, although the oil producer is well positioned to a low oil price world, the firm faces major execution risks, particularly with the development of key offshore wells. Project delays and cost overruns are common in the industry and may be uncontrollable given external factors, such as regulatory issues and geopolitical challenges. The result of such potential execution failures could send shares in the company sharply lower and negatively impact the firm's overall profitability.
Meanwhile, Genel Energy(LSE: GENL) is producing low-cost oil right now. Operating in Iraq's Kurdish region, the oil producer has a break-even oil price of around $20 per barrel, well below the industry average.
As a low-cost producer, Genel is profitable throughout the commodities cycle. But unlike Cairn Energy, Genel already has in place significant production assets. This means Genel's earnings is currently benefiting from the already recovering oil price, and shares look attractive on a valuation perspective. Shares in Genel trade at 17.5 times its expected 2016 earnings, and 14.3 times earnings in the following year.
Buy and hold?
Jack Tang has no position in any shares mentioned. 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.