If you’re looking to invest in the oil sector next year, Royal Dutch Shell (LSE: RDSB) and BP (LSE: BP) should be on your hit list.
The two oil giants have many advantages over their smaller peers, such as strong balance sheets, integrated operations and some of the lowest production costs in the business. Indeed, it doesn’t make sense to buy into the smaller producers such as Tullow Oil, Premier or Enquest when shares in Shell and BP are both on offer.
For income investors, both Shell and BP offer an attractive proposition at current levels. Shell’s shares support a dividend yield of 8%. BP’s shares yield 7.2%, and both companies are taking drastic action to ensure that their dividend payouts remain in place for the foreseeable future.
City analysts believe that during the next 12 months, the breakeven price of Big Oil – the level at which it makes a cash profit – will fall by 20% to $80 per barrel. A further decline in costs to $60 per barrel is expected by 2017.
Held back
Even though Shell’s shares may support a dividend yield of 8%, they’re unlikely to outperform the market next year. You see, many analysts and investors are concerned about Shell’s decision to buy BG Group.
There’s no denying that the Shell-BG merger is fraught with risks, especially when you consider that the oil industry is facing an unprecedented period of pain.
Still, Shell has built a reputation for excellent project management over the years, and now more than ever the company needs to show that it can execute.
To reassure investors that the deal does indeed make sense, Shell has hiked the dollar value of savings it expects to generate by combining with BG. An additional $1bn in savings will come from cost cutting in back office functions, marketing and shipping, which had already been expected to save $1bn a year.
Further, the enlarged group will be able to save $1.5bn per annum from a cut in exploration activities, as the combined group spends less on searching for new oil fields.
Only time will tell if these cost savings are realistic. As I mentioned above, now is the time for Shell’s management to demonstrate that it can execute and successfully integrate BG.
Dividend safety
On the other hand, BP’s shares should outperform if the company can show that its dividend is sustainable.
The company’s yield of 7.2% is almost double the FTSE 100 average. However, if BP can prove that this yield is here to say, income investors will buy-in and keep buying until the yield returns to a more normal level of around 5%. BP’s shares would hit 520p before the yield reached this level.
Management is already taking steps to reassure investors that the payout is here to stay. Capital spending has been slashed by a fifth for 2015 and BP has halted buybacks to free up more cash for the dividend.