Outlook for BP and Shell in 2017

The last few weeks have been a haven for long-suffering oil investors, with OPEC's production cut coinciding with brokers releasing detailed tips for 2017.

There's more to learn about the agreement, but Deutsche Bank thinks we should be happy that the oil cartel has finally acted. It's also given its verdict on FTSE 100 oil majors Shell and BP.

OPEC is shedding 1.2 million barrels of oil per day (bopd) to 32.5 million barrels from January, and the Russians are cutting back, too.

This is a major shift for the oil bloc, which initially decided to prioritise long-term market share - chiefly trying to put North American shale drillers out of business - over any short-term pricing issues.

Put simply, it's finally realised the oil industry just doesn't work at $50 per barrel (/bbl).

As we enter the final weeks of 2016, the International Energy Agency's (IEA) initial 95.2 million barrel per day (bpd) forecast for the year has been increased by a further 1 million barrels to 96.2 million. Non-OPEC production is downgraded by 1.3 million bpd below initial expectations to 56.7 million.

Supply and demand

So, with higher demand and lower non-OPEC supply, the oil industry must have been working its way through its supply glut - right?

Wrong. Production increased by 2 million bpd to around 33.8 million from July 2015 to November 2016, and the markets are still swinging out of balance.

Deutsche has pencilled in $55/bbl in 2017, rising to $65/bbl a year later"With demand higher and non-OPEC supply lower, it is OPEC and its ongoing willingness to pump ever more oil in its push for market share and income that has undermined global oil markets," explains Deutsche Bank analyst Lucas Herrmann, "not the US onshore, not a collapse in demand, not the build out of new provinces. Very simply, OPEC".

So while there is still much chatter over the finer details of the Vienna deal, Herrmann takes comfort in knowing output is no longer "33.8 million bpd and rising".

With 2017 demand set to rise again, the analyst is convinced that inventories will start to draw down next year, which will strengthen the oil price and oil companies with it. Deutsche has pencilled in $55/bbl in 2017, rising to $65/bbl a year later.

After two years of painful restructuring, slashing of capital expenditure budgets and operational cost cutting, balance sheets in the industry finally look resilient again. Dividends are covered, banking covenants aren't being tested across the board and valuations are much more attractive.

Project start-ups and falling costs, with rising oil prices, should drive up cash flow"After two years of abject misery 2017 is shaping up to be a year where the sector hits a sweet spot," says Herrmann.

"Project start-ups and falling costs at a time of rising oil prices should conspire to drive a meaningful improvement in cash flow. Moreover, with the project conveyor belt only starting to gather pace look to 2020 and the cash flow ramp in our opinion has only just begun."

With the cogs of the global supply/demand balance beginning to move, Deutsche Bank reckons now is the time to take more risk. Below, the analysts explain how the next phase of the oil cycle will impact the two London-listed oil majors; Royal Dutch Shell and BP.

Royal Dutch Shell

'Buy'

Target price: Upgrade to 2,450p

Potential upside: 14%

Following its acquisition of BG Group earlier this year, Shell now has an attractive portfolio mix of deepwater, tight oil and liquefied natural gas (LNG) assets, and a 15-year resource base representing $70 billion (£55.6 billion) of investment potential offering 20% return. It's also got free cash flowing into the business from its downstream and LNG divisions.

"Fundamentally, Shell has all the ingredients for a peer beating portfolio and returns," says Herrmann.

Of course, it must make itself more agile in the face of $80 billion of debt. However, if the bottom of the cycle has indeed passed, the blue-chip should be able to make asset disposals to enhance cost cutting and tight investment budgets.

Shell is also much more exposed to macro trends, so the OPEC decision can only improve the investment case.

For every $10 the oil price increases, Shell bags an extra $5 billion in cash flow from operations, we're told. The oil major is the analyst's top pick in the sector and the target price now rises from 2,200p to 2,450p, giving a 6% prospective yield.

BP

'Hold'

Target price: 505p

Potential upside: 10%

BP is exiting 2016 a very different company to how it entered. Concerns over its ability to grow and rebalance whilst maintaining its dividend gave way as the company used resource acquisitions, project progression and improvement in portfolio quality to warm hearts.

Now investors are confident the company can work at $50/bbl in 2018, getting stronger over the next decade.

Currently, BP's kryptonite is Macondo in the Gulf of Mexico, where the cost of resolving claims made a serious dent in cash flow. Until these outflows ease back - expected in mid-2017 - Deutsche Bank maintains its 'hold' recommendation.

"There is in our view a huge amount to like at BP. Management is, we believe, absolutely committed to managing the portfolio tightly and with considerable investment discipline seeing further material potential in cost reduction at the same time," explains Herrmann.

He is also convinced shareholders will reap the rewards of improved returns and growing cash flow.

"An ex Macondo breakeven of c$50-55/bbl in 2017 will we suspect have fallen to nearer $45/bbl by 2019 adding good confidence in BP's ability to sustain and perhaps grow dividend."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.