The major consideration for any investor is the relationship between risk and reward. Clearly, rewards need to be greater than risk, or else investing is perhaps not a worthwhile action to take. However, the challenge is that rewards are often greatest when risk is also relatively high, with it being unusual for a company’s share price to trade at an appealing level (thereby offering great rewards) without good reason.
That’s the situation at the present time in the oil sector, with a depressed outlook for oil causing the share prices of some high quality companies to be relatively cheap. For example, Shell (LSE: RDSB) (NYSE: RDS-B.US) is one of the biggest, most diversified and financially sound oil companies in the world and yet trades on a price to book (P/B) ratio of just 1.15. This indicates that, while there is scope for asset write downs over the medium term if the oil price once again resumes its downward trend after its recent spike, Shell’s valuation offers a wide margin of safety that minimises risk and offers significant potential reward.
It’s a similar story with Premier Oil (LSE: PMO). Unlike Shell, it offers only limited diversity but, like Shell, it has a very appealing asset base, is well-run and is creating efficiencies in an attempt to make itself more competitive should oil remain at well below $100 per barrel. It trades on a P/B ratio of just 0.72 and, while its financial standing may not be quite as appealing as that of Shell, its lower valuation means that its risk/reward ratio remains very favourable. That’s especially the case since both Shell and Premier Oil are expected to return to profitable growth in financial year 2016.
Meanwhile, the oil services sector has also seen its valuations hit by a lower oil price, as reduced capital expenditure from oil producers has hit their top and bottom lines. For example Wood Group (LSE: WG) and Petrofac (LSE: PFC) have seen their share prices slump by 6% and 25% respectively in the last year, and this creates a superb opportunity for investors to buy in at a great price.
For example, Wood Group now trades on a P/B ratio of just 1.52, while Petrofac has a P/B ratio of 2.37. Although higher than those of Shell and Premier Oil, both still offer huge appeal. That’s because, in the case of Wood Group, its bottom line has not been hit particularly hard (compared to other oil-focused companies), with its earnings expected to be flat this year and to fall by only 5% next year. Meanwhile, Petrofac is expected to deliver a rise in net profit of 56% next year, which makes its current valuation appear to be very enticing.
And, with both companies having seen their share prices rise by 13% (Wood Group) and 10% (Petrofac) in the last three months, investor sentiment appears to be on the up, which bodes well for their medium term performance.