BP plc andRoyal Dutch Shell plc aren't out of the woods just yet

Updated: 
Shell

It's been a good few weeks for investors who kept faith in oil majors' ability to survive slumping prices. First there was the OPEC supply cut agreement made in Algeria and then Q3 earnings season rolled around and included a slew of positive trading updates. BP (LSE: BP) posted a $1.6bn replacement cost profit, a 34% jump from last year's number. And Shell (LSE: RDSB) earned $1.4bn on a current cost of supplies basis, a long way from the $6.1bn loss recorded this time last year.

And while I still count myself among those who believe oil majors will remain a viable investment for years to come, the short and medium-term outlook for each company remains cloudy at best.

When talking about oil companies the most important question to ask is about where oil prices are going. Of course, no-one can say for certain in the short term but there are undeniably factors limiting runaway growth.

First, the mooted supply cut from OPEC producers is far from a done deal. While a tentative agreement was reached in September, analysts across the industry are beginning to doubt whether this will amount to much. Exempt countries such as Nigeria and Libya are ramping up production and non-OPEC countries and companies are still pumping prodigious amounts of oil.

Second, it's looking as $50/bbl is indeed the point at which US producers are ready to jump back into the game. Rig counts in the US are still below where they were a year ago but have been steadily rising. So even if OPEC gets its ducks in a row it's highly possible that American producers will counteract any positive effects and make $50 the new price ceiling.

Debt loads

That said, equilibrium will be restored eventually as oil majors continue to cut back on finding and developing new fields, which means total supply will at some point fall enough for prices to rebound. The problem for BP and Shell right now is that both are piling on debt at a rapid clip as they attempt to balance the capex necessary for long-term growth with the short-term desire to maintain uncovered dividend payouts.

In Q3 alone Shell paid out $3.8bn in dividends. Issuing new shares covered $1.1bn of this, but that is of course dilutive for current shareholders. With operational cash flow not nearly enough to cover this outlay Shell was forced to take on additional debt which, together with the acquisition of BG Group, sent the company's gearing ratio up to 29.2%. It's a similar story for BP, where gearing now stands at 25.9%.

Now BP says it will be able to balance dividend payments and capex with operational cash flow next year with the price at $50-$55/bbl, Shell will be targeting similar levels and drastic cost-cutting combined with asset disposals have certainly made dividends appear safer than they did at the beginning of 2016. Still, Shell is rapidly approaching the upper limit of the 20%-30% gearing band it feels comfortable with and if oil continues to trade at around $45/bbl for the foreseeable future, then both companies will have tough decisions to make. Placate investors now and sacrifice long-term growth, or slash dividends and begin to nurse their balance sheets back to health.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended BP and 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.


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