Big Oil stocks have made a remarkable recovery over the past year. Royal Dutch Shell(LSE: RDSB) B shares are now selling for close to 2,400p, following a gain of 77% over the past 52 weeks. Meanwhile, BP(LSE: BP) has delivered a slightly weaker, but still respectable gain of 54% over the same period.
The oil price has made an impressive comeback too, propelled by OPEC's production cut and forecasts of strong oil demand growth in China and India. Brent crude oil is now selling for near $56 a barrel, around 80% higher than a year ago.
But despite the rally in oil prices, Big Oil continues to face a number of challenges that could hold back further gains in the share prices.
Oil price outlook
The prospect for further oil price gains this year is still unclear. That's because, despite efforts by OPEC and Russia to cut production, a global supply glut will likely persist. Global oil inventories currently stand at record levels, and higher oil prices could lead to accelerated drawdowns, which could offset the impact of production cuts. In addition, rising commodity prices could encourage higher-cost producers to increase output and take market share.
That said, Big Oil companies have made significant changes to adapt to current market conditions. Shell and BP have cut operating costs, scrapped expensive projects in risky oil frontiers, slashed capital expenditure and sold non-core assets to survive in a lower-for-longer price environment.
Going forward, Shell expects to balance cash flow with asset sales throughout the cycle, while BP goes even further, by promising to cover capital spending and dividends from organic cash flow if the oil price remains above $50-$55 per barrel this year.
The biggest threat to Big Oil earnings is, of course, oil price volatility. However, it's not the only threat. Falling refining margins is almost as troublesome right now, as falling downstream profits could offset much of the gain in upstream profits from rising oil prices. Already, refining margins are beginning to weigh on their results, and further falls seem likely given excess supply and growing inventories in North America and Europe.
With both stocks currently yielding more than 6%, it's clear that Shell and BP's big dividends are a big draw for income seekers. But, are they really good income investments?
Personally, I think there are better dividend shares available for investors to buy today. Although Shell and BP offer tempting dividend yields, there's little prospect of dividend growth for either stock. Over the past two years, dividend cuts have only been avoided by asset sales, and even with the improved earnings outlook, dividend cover is forecast to remain well below the widely-regarded safety benchmark of one for some time. So, while a dividend cut seems far more remote with the recent oil price gains, the longer-term dividend outlook isn't very appealing.
Jack Tang 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.