The recovery in ‘Big Oil’ earnings likely stalled in the second quarter of 2017, according to Morgan Stanley analyst Martijn Rats, but, he reckons London-listed Royal Dutch Shell Plc (LON:RDSB) and BP Plc (LON:BP.) are still “set to fare reasonably well.”
Rats, in a note, described the crude market economics as “somewhat worrisome” looking into 2018, and he says oil companies will be contemplating how to respond.
“Nearly three years into the downturn, global oil reserves are still higher than ever before, non-OPEC production is back to growing >1 mb/d year/year, and the earnings recovery of the last few quarters appears to have come to an end,” Rats said.
“We forecast European Integrated Oil earnings to decline ~35% quarter/quarter in 2Q.”
Cash will continue to be key for investors
“Given the recent volatility in crude prices and expectations for a challenging macro environment, we expect the market to continue to focus on cash flow generation and balance sheet strength.
“Despite weak results, asset sales will likely ensure that the momentum in sector's de-gearing continues into 2Q17, in our opinion.”
Specifically looking at the Shell, meanwhile, the analyst has a price target of £25.60, some 24% above the current price of £20.67 per share. This, though, is Morgan Stanley’s base case – the ‘bull’ case sets an optimistic bar of £30.80, while the bear case sees the price down at £18.80.
Rats sees Shell’s valuation remains attractive compared to its ‘Big Oil’ rivals.
“Shell's dividend yield remains stubbornly high,” he said.
“It is the highest of the global majors, discounting greater concerns over dividend sustainability than for any of its peers. In our opinion, this is not justified. 12month forward consensus free cash flow (FCF) estimates have also improved substantially.”
Attractive dividend yield and cover
At the same time, the analyst points to BP’s “attractive combination of dividend yield and dividend cover”, as his 510p ‘base’ target price suggests 14% upside to the current price of around 448p – the upside case is pitched at 510p, whereas 400p is the ‘bear’ case target.
“BP's free cash flow is set to improve meaningfully over the next two years. Typically this acts as a catalyst for yield contraction,” he added.
“Given BP's current yield premium, the scope for its yield to come down is extensive, skewing the risk/reward in a favourable direction.”