Wednesday, 6 February 2013

Oil is a better investment than Gold

And Royal Dutch Shell 'B' - At What Price?

Achaemenid coin @420 BC (from Wikipedia)

Gold coins have been in circulation since about 600 BC, and everywhere on the planet gold has been valued for its colour, malleability, durability and scarcity. Pure gold does not tarnish. The last significant link of gold to money ended in 1971, when the US ceased to back the dollar with the metal. But gold lives on in our imagination as a store of value.

No one, in their sane mind, would hoard oil. Yet many people hoard gold. No doubt if it were as easy to store oil as gold and as difficult to store gold as oil, the situation would be reversed.

The price of gold has increased by 4.4 times since 1982. A share in the oil major Royal Dutch Shell (formerly Shell Transport & Trading in the UK) has increased by 15 times since 1982. And during these thirty years Shell has paid out an annual dividend averaging about 4%.  The other oil major listed in London, BP, has increased its value by 10 times, while paying out dividends of about 4.5% annually. Shell and BP have outperformed gold as an investment by a country mile.

Compound annual returns % in sterling 1982 - 2012:

 Brent Crude Oil
  1 Share in Shell
1 Share in BP
Retail Price Index

The three largest gold miners in the world have proved to be a better investment than gold over the long period.

Compound annual returns % local currency:
Barrick Gold
Return p.a.

The difficulty for the UK investor is that none of these miners were quoted on the London Stock Exchange in 1982. Of the three, only Newmont Mining had any sort of track record. Barrick Gold was founded in 1983 and Goldcorp in 1995. London quoted gold miners are often fully invested in one or two countries, with all the political risk that entails, or are managed in countries with greater political risk than the UK: the largest, Polyus, is based in Moscow; and the second largest, AngloGold Ashanti, is based in South Africa. Anyway, gold bugs are lured by physical gold rather than the flimsy paper of a miner's share certificate. They will have noted that few miners have kept pace with gold in the last 10 years, when the gold price has risen by a compound 17% p.a.

Gold is a useless mineral compared to oil. Oil is essential for economic activity, and processed oil in the form of plastic and textiles is always at hand and in sight. This helps to explain the vast difference in the size of the two industries - the largest gold miner, Barrick Gold, is one-fifteenth the size of the largest non-State oil company, Exxon Mobil (and Exxon Mobil is overshadowed by some of the State owned oil companies). As about 33% of gold production goes directly to hoarders and a further 55% to make jewellery, little is put to productive use. Annual gold demand, including hoarders, is only 2% of the world's gold stock.

Gold, which yields nothing but the promise of capital gain, is a casino chip. A share in an oil company is a share in a thriving business. That is not to deny that a gold bracelet is prettier than a plastic one.

Royal Dutch Shell 'B' - At What Price?


A combination of long-term investments going back a century, technological know-how, market access and management skills have enabled Shell and BP to perform well (despite some serious setbacks) in the oil business. BP, after the Deepwater Horizon disaster, is going through a major restructuring that includes the sale of its half share in TNK-BP and reinvestment in Rosneft. BP has unfathomable contingent liabilities from civil lawsuits and in the form of government fines. BP, at the moment, is impossible to value.

By default, Royal Dutch Shell 'B' (RDSB) is the oil major of choice for the UK investor. The company is very large - the 10th largest in the world by market capitalization - and conservatively financed.  The company carries net debt of only 10% of equity and its debt is rated AA by Standard & Poor's. Shell's dividend yield of 4.8% is 2.4 times covered by earnings, and the dividend has increased by 6.5% per annum, or about twice the rate of inflation, in the past 10 years. Free cash flow, after paying the dividend, has exceeded the gargantuan capital expenditure requirements of the business these last two years by $24 billion.

Operationally, Shell's strength derives from its diversified upstream activities, its large refining capacity, second only to Exxon Mobil, and its retail presence. Earnings per share have increased by 3% per annum in the last ten years, while equity per share has increased by 10% per annum, thanks largely to the fourfold increase in the price of oil. Not all are positives. The company's production (barrels of oil equivalent) has declined by 15%, although its stated reserves have increased by 20% in these ten years; but 12% of Shell's oil and gas reserves are in Canadian tar sands, which are very costly to extract and refine. Shell has spent $4.5 billion on Arctic drilling and is not even in sight of production. Finally, the company will take a 10 billion pound charge to its balance sheet (Lane, Clark & Peacock estimate) to meet the pension fund requirements set out by the amended IAS19.

At 2271p, Shell stands on a PE ratio of 8.4. A valuation model for Shell throws up 2407p as a price worth paying for its share. This valuation is an average of three calculations based on a) Earnings (2024p), b) Return on Equity (2406p) and c) Equity per share (2791p) for the five years 2013-2017. The assumptions are:
1. EPS growth of 3% pa.

 2. Return on Equity of 14%.

 3. Increase in Equity per Share of 10% p.a.

 4. A discount rate of 11.3% (3.3% is Shell's weighted cost of debt plus 3% for operational risk and 5% for profit and safety).

 5. An average PE ratio of 9.

 6. Retained earnings are 72% of profit after tax.

7. All for the five year period 2013 to 2017. 

The share price of Shell has fluctuated between 2020p (18 May 2012) and 2485p (7 February 2012) in the last 12 months.
However, before investing the cautious investor will consider the following risks for Shell:
1. Oil and gas are commodities and the company has no control over pricing.
2. State owned oil companies have an upstream competitive advantage over Western-owned oil majors.
3. Future upstream production and revenues "depend on delivery of large and complex projects" (Company comment).
4. Damage to the environment is increasingly costly and increasingly likely with the new extraction techniques that Shell must follow to find new reserves.
5. Political risk is an ever present threat to the oil industry.






  1. The most readable financial column I have ever come across.
    thank you.
    Keep it up.

  2. Ditto! I just wish it would attract more comments so as to generate more discussion around these very well structured articles.

  3. Thanks Altijdlente. Perhaps the structure of the articles does not encourage comments. But all are welcome.

  4. Excellent stuff - you're in my browser 'favourites.'


  5. cvx has done very well over the past 10+ years or so. hopefully we can look forward to some further comment on the #2 oil co. in the busines that is not gov. owned.

  6. Anonymous - I have limited the analysis of stocks to companies with a London listing. This is my own area of expertise. Of course their are many high quality stocks listed on other markets. Chevron is certainly worth a view.