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Shell-BG Merger Benefits Becoming More Clear

: May 8, 2017

When I decided to position for a coming oil price recovery towards the end of 2015, I decided on buying Shell (NYSE:RDS.A), alongside Suncor (NYSE:SU) and Chevron (NYSE:CVX). My investment strategy always has a longer term horizon, therefore Shell was an obvious choice, given the very generous dividend. When deciding to hold a stock for a number of years, it really makes a difference, as long as the dividend is sustainable, of course.

There were other factors which I saw as positive long term prospects that makes Shell stock worth holding on to for a while. Shell’s leadership in the LNG sector, in large part thanks to the BG deal is one of the things that attracted me to the stock. As I stated many times before, I believe that natural gas will eventually become the number one energy source on the planet and as such it will have to become more flexible in terms of delivery. LNG shipments will most likely become a globally strategic industry, which is likely to grow a lot in coming years and decades.

In this regard, for the shorter term I see increased odds of much higher LNG demand coming from Europe. The Nord Stream 2 pipeline project linking Russia and Germany is still facing some obstacles. The latest is a Danish legal challenge which may yet derail the project. In the meantime the Ukraine transit route remains unstable, together with the country of Ukraine itself, which is continuing to face grave economic problems. In addition to that, there is the fact that domestic EU natural gas production continues to decline. The Netherlands in particular is seeing a dramatic decline in production. Shell’s own Q1 report is forecasting a drop of 50,000 b/d in oil equivalent production in its Netherlands projects. That is the equivalent of 3 Bcm, or about .5% of the EU’s total yearly demand. Many people are unaware of this fact but in 2012 Netherlands natural gas production accounted for about half of the EU’s total domestic supply. The continued decline is leaving an ever-wider gap in EU gas supplies, leaving the EU with the choice of more Russian gas which is politically sensitive, versus more LNG, which tends to be more expensive.

With total projected Shell LNG capacity reaching 45 million tons per year next year, it is no wonder that Shell is now publishing its own LNG outlook. Global LNG demand was 265 million tons in 2016, so by next year Shell will likely control 15-16% of the market. I am assuming an average yearly increase of 4% in LNG demand when projecting demand next year. It is the outlook that Shell itself is projecting, so there may be some bias, but looking at certain factors, it seems to make sense. It expects LNG demand to continue increasing at an average rate of about 4-5% per year until 2030, with China alone adding perhaps as much as 100 million tones of yearly demand by then.

Shell’s path is proving to be profitable.

in the past few years Shell made quite a few moves to re-orient its operations. It scrapped its 100,000 acre shale holding in Dimmit county, Texas, accepting a $2 billion loss in order to sell it to Sanchez Energy. It scrapped its planned gas to liquids plant in Louisiana. And then went ahead with the big BG merger for $70 billion, which market consensus declared to have been a bad deal. The latest quarterly report however confirms that Shell’s current operations are adequate in terms of providing profitability at current oil & gas prices.

It announced total revenue of over $73 billion for the quarter, with income coming in at $3.37 billion. Capital costs came it at $4.7 billion, which is a major factor we have to look at when it comes to oil & gas producers in my view. There is a definite correlation between profitability and the CAPEX/revenue ratio, as I pointed out in previous articles.

As we can see, there is a very wide gap between global oil majors such as Shell and Chevron, which are diversified in terms of sources of oil & gas, as well as in terms of upstream, midstream and downstream and shale producers on the other side. There is also a relatively significant difference between Shell and Chevron in this regard. But both have been reporting quarterly profits for a few quarters now, while the shale producers I chose for comparison are struggling to do so. EOG (NYSE:EOG) for instance, which is regarded as being among the best in the shale patch reported a loss for the previous quarter. It did not report yet for the latest quarter, but I expect that even if it will manage to break even or report a slight net income, most of its shale peers will not.

It is this aspect of Shell that I find intriguing. While more and more companies are increasingly becoming reliant on shale resources in order to replenish reserves and to increase production or at least keep production flat, thus gradually eroding profitability, Shell has been looking for other avenues. This is not meant to deny the fact that it is also involved in shale. But it focuses a lot of its attention on complementing shale production with value-added projects. LNG is in effect a value added activity. So is the chemical plant project in Pennsylvania meant to take advantage of the low natural gas prices in that region. It is also not afraid to scrap projects that are not in the long-term financial interest of the company, such as its Catarina shale project on which it took a $2 billion loss. It is now gone and it is Sanchez Energy (NYSE:SN) who is losing money on drilling it every quarter. It also scrapped the GTL project in Louisiana once it figured the risk of taking a loss on that investment is too high.

It more recently shed its oil sands operations, in a deal worth $8.5 billion. While I am a firm believer in oil sands profitability in certain instances, which is why I own Suncor , which as I pointed out is proving to be far more profitable than most shale producers, it is also true that many companies are losing money in oil sands. Here too Shell seems to be showing a distinctly different culture. It is less obsessed with needing to maintain reserves and production, therefore it is able to shed less-profitable operations.

Shell would not be able to do this of course, if it were not for the fact that thanks to the BG deal it can afford to be complacent about reserves and production elsewhere. The purchase of BG has been viewed as too expensive, but it is thanks to that deal however that Shell can shed less profitable projects, which otherwise might have ended up being permanent financial drains on the company. It is an aspect that is seldom considered, because there still seems to be near-universal consensus that opportunities for production growth such as in shale are wildly profitable, despite quarter after quarter showing otherwise. It is this dynamic which has not been factored in by the market when it almost universally declares the BG deal to have been too expensive. Because the market continues to ignore it, there continues to be value in being invested in this stock, because eventually financial results driven by longer term fundamentals always prevail over shorter to medium term sentiment.

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Disclosure: I am/we are long RDS.A, SU, CVX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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