Just sixteen months ago, Shell (LSE: RDSB) was riding high at almost £26 per share. The oil price was over $110 per barrel and Shell was on target to increase its earnings by over 10% versus the previous financial year.
Today, the company is a shadow of its former self, with its shares trading almost a third lower, its net profit forecast to slump by 34% this year and the oil price 55% lower at around $50 per barrel.
Clearly, the major challenge which Shell faces is a lower oil price and, looking ahead, it seems plausible that the price of black gold will remain weak in the coming months. After all, there is a global supply/demand imbalance which is unlikely to change in a short period of time.
However, in the medium to long term things could be a lot different. That’s because global energy needs are expected to rise by 30% in the next twenty years and, while renewables will become a more important part of the energy mix, fossil fuels such as oil are still set to dominate their cleaner peers. And, with exploration spend falling across the industry, the supply of oil seems likely to fall – especially since a number of smaller operators are uneconomically viable with the oil price being so low. As a result, a much higher oil price over the coming years seems to be very likely.
The present time, then, is all about survival and positioning a business to take advantage of the opportunities which a weak oil market inevitably brings. On both fronts Shell is making strong progress. It has a supremely strong balance sheet and excellent cash flow, with it making sensible decisions to, for example, cease exploring the Arctic and also sell-off non-core assets. Furthermore, it is also in the market for undervalued assets such as BG, with its balance sheet having the capacity to withstand a considerable rise in debt should Shell wish to further increase its market share.
Clearly, Shell is suffering from weak investor sentiment. Evidence of this can be seen in its valuation, with the company currently trading on a price to earnings (P/E) ratio of just 13.6. Looking ahead to next year, Shell is forecast to increase its earnings by 5% which is roughly in-line with the wider market’s growth rate. As such, an upward rerating is very realistic, but would not be enough to push its shares to anywhere near the £26 level achieved in May 2014.
To reach such heady heights, earnings growth is a requirement. If Shell were to maintain its current rating and increase its bottom line at an annualised rate of 8% per year for the next five years, it would be sufficient for its shares to trade at £26. In other words, its earnings per share would need to rise from 131p to 191p in five years, which requires a growth rate of 8% per year so that when multiplied by a P/E ratio of 13.6, the end result is a share price of £26.
Although such growth may seem rather unlikely to a lot of investors, things can change very quickly in the resources sector. Shell’s share price collapsed by a third in just sixteen months. Growth of 46% in sixty months is very much on the cards – especially when Shell’s financial strength, acquisition potential, strategy, as well as the potential for a rebalancing of demand and supply in the wider oil sector, are taken into account.