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Is Autumn the Right Season to Buy European Energy Stocks?

October 24, 2013 | About:
With the summer already behind, the stock exchange began to move again. And, as the Northern Hemisphere approaches the winter season, energy companies get ready for the yearly seasonal high demand. Europe, specifically, will face particular challenges due to the unfavorable macroeconomic environment. The question that remains is: which energy companies do gurus see as safe investments? Here, I will take a look at the two largest European energy companies, Royal Dutch Shell (RDS.A) and BP (BP).

Legal claims, restructuring, and declining stock price

When measured by market cap, BP is second largest European integrated energy firm behind Royal Dutch Shell. The gap between the two was widened after the British based multinational sold $38 billion worth of assets in response to the Deepwater Horizon incident. Asset divestiture carried a simultaneous effect, the reduction of proven reserves by almost 20%. But the most important consequence of the incident is the unwanted publicity, compounded by a sudden and strong drop on stock price.

At the beginning of the month, BP received a favorable ruling by the Fifth Circuit Court of Appeals regarding the issue of business and/or economic loss claims were being paid. The lawsuit related to the settlement concerning the aforementioned incident. The ruling sets an aura over the firm and positively feed future prospects. Nonetheless, the issue has not been fully resolved and a new round of legal battles is expected on the next couple of months. What the recent ruling did is to erode is to erode the certain key elements the plaintiffs used to base their business and/or economic loss. Hence, a smaller cash outflow is also expected.

Looking ahead of court rulings, BP´s divestiture of upstream non-core operations will create a stronger portfolio from a smaller base and this is expected to benefit overall performance. Another important characteristic is the accumulated know-how about unconventional gas. This is especially important since the company holds interests in the Woodford, Haynesville, Fayetteville, Eagle Ford and Utica shale. International exposure is another key to forward performance. Throughout 2013 the activities in Brazil, India, North Sea, Gulf of Mexico, Angola, Egypt, Jordan, and Indonesia have intensified through new exploration and production projects.

Although the last guru transaction is Manning & Napier Advisors sale of 31% of its stake, the two largest gurus holding a position, James Barrow and Seth Klarman, have raised their share twice during 2013. Financially, BP is moderate due to a high debt and troubled cash flow balance related to business and/or commercial loss claims. I do not share Barrow and Klarman’s optimism because stock price has been on a steady decline since the Deepwater Horizon incident, related legal claims have been partially settled, and the 46% discount to the industry average is an evidence of the risks associated with the stock.

Legal claims, overspending, and portfolio concentration

Royal Dutch Shell is another European giant involved in legal battles. In this case the lawsuit originates in Niger Delta region, in relation to two oil spills occurred in 2008. The case presented to the London Court of International Arbitration in 2010, to claim settlement for environmental and lifeline damages to the Bodo community. Although stock price recovered some ground after the litigation was made public, a declining pattern can be observed since April, 2011.

Looking forward, Royal Dutch Shell continues to spend more than the industry average on investment projects. The implications are deteriorated credit metrics and smaller returns. Also, a heavy reliance upon downstream operations leaves a company less diversified than the competition. That is compounded by a great focus upon gas operations, putting the business model at a greater risk than the completion due to volatility. Last, the great international exposure has taken the firm to the unstable and risky corners of the world.

On the upside, besides the comparatively concentration of Royal Dutch Shell’s activities around downstream and natural gas, the firm retains a wide and diverse portfolio. Most importantly when looking forward, it holds a strong inventory of development projects and sufficient capital to raise production level. The upside to a focus on natural gas operations is the company’s leading market position thanks to an economy of scales and technology innovation.

The balance sheet for Royal Dutch Shell is spotless and has improved year-over-year for the last three consecutive years. Currently trading at 8.9 its trailing earnings, the stock offers a small discount. Richard Pziner, the guru with the largest holding in the company, has been taking advantage of a combined low stock price and discount. However, I do not share his sentiment since even with rising dividends.

Unsecured future

Having legal rumbles pending resolution is a grave question marked for any company. The weight is even heavier when it comes to environmental damage because there is no precedent. That absence has pushed plaintiffs to present ambitious lawsuits. And although they have not been very successful, the risk implied is too big, especially for a long-term investment. Hence, I prefer to remain on the sidelines and wait to see how BP and Royal Dutch Shell resolve their legal issues.

Disclosure: Vanina Egea holds no position in any of the mentioned stocks.

About the author:

Vanin Aegea
A fundamental analyst at Lone Tree Analytics

Visit Vanin Aegea's Website


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