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Royal Dutch Shell: The Cash Machine

 Nov. 6, 2017 12:35 PM ET

Summary

  • Royal Dutch Shell has reported nearly 50% increase in profits following improvement in energy prices which fueled a turnaround of its upstream division.
  • In the first three quarters of 2017, Royal Dutch Shell generated $15.42 billion of free cash flows (ex. working cap. changes), surpassing even the industry’s cash flow king Exxon Mobil.
  • Oil prices have climbed to almost $61 a barrel and could stay at this level in the future, which could give a major boost to Shell’s earnings and cash flows.

Royal Dutch Shell (RDS.A, RDS.B) is a well-oiled cash flow machine. In fact, it generates more free cash flows than any other oil majors, and this was evident from the latest quarterly results. The Anglo-Dutch oil giant could get even better in 2018 on the back of improvement in oil prices. The company’s shares will likely move higher while its valuation might also improve.

Latest Earnings

Royal Dutch Shell has recently released blowout quarterly results in which it posted significantly higher profits following a strong performance from its upstream, downstream and integrated gas divisions. The company reported an adjusted net profit (attributable to shareholders on a current cost of supplies (CCS) basis) of $4.1 billion, up 47% from the same quarter last year. That blew past the company-provided analysts’ estimate of $3.6 billion. The profits at the upstream segment ballooned from just $4 million a year earlier to $562 million. The profits at the downstream and integrated gas segments rose 28.4% and 37.7% to $2.67 billion and $1.28 billion respectively.

The highlight was the turnaround of Shell’s upstream business which can be attributed to improvement in commodity prices. Shell’s realized price for liquids (mainly crude oil and NGL) averaged $47.06 per barrel in the third quarter, which shows an increase of 16.4% from a year earlier, while the realized price of natural gas came in at $4.15 per thousand scf, which was 21.3% higher than last year. The upstream production volumes were largely flat from last year at 2.66 million boe per day, thanks in large part to new field start-ups and ramp-up of existing projects in Brazil, Kazakhstan, and the US Gulf of Mexico which lifted the company’s production by 243,000 boe per day and offset the negative impact of asset sales. Total production, after including integrated gas, climbed from 3.60 million boe per day in Q3-2016 to 3.66 million boe per day. The company’s LNG liquefaction volumes rose almost 10% to 8.45 million tonnes as the Gorgon facility in Australia came online.

Shell has also improved its financial health by reducing its net debt from $77.84 billion at the end of Q3-2016 to $67.66 billion. The company’s leverage ratio has also improved from 29.2% a year earlier to 25.4%.

Cash machine

In the last few quarters, Shell has posted some of the strongest levels of cash flows in the industry. Generating enough cash to fully fund its capex and dividends has been the top priority for the company which amassed a massive pile of debt following the $52-billion-takeover of BG Group. In the third quarter of this year, however, Shell’s operating cash flows fell 10.7% from last year to $7.58 billion. Although cash flows easily covered capex of $5.02 billion, leading to free cash flows of $2.56 billion, it wasn’t enough to cover all of the dividends of $3.02 billion. As a result, the company faced a cash flow deficit of $452 million. But I don’t think this is alarming since the weakness in operating cash flows was due to the adverse impact of changes in working capital, rather than any operational problems. Excluding changes in working capital shows that Shell remains a cash flow machine.

In the third quarter, Shell generated more than $10 billion of cash flow from operations, which was more than twice as large as its capex. This translated into $5.03 billion of free cash flows, which funded the dividends and led to $2.02 billion of excess cash flows. That’s taken Shell’s free cash flow tally for the first nine months of this year to an incredible $15.42 billion. That funded dividends of $8.6 billion and the company ended the extended period with $6.8 billion of excess cash. To put this into perspective – no other oil major has generated higher levels of free cash flows in the first nine months of this year. Shell has even outperformed Exxon Mobil (XOM) who is often regarded as the energy industry’s cash flow king. As shown in the table below, the former generated higher levels of free cash flows and excess cash than the latter in the first nine months of this year (excluding changes in working capital).

Looking ahead

Shell has delivered a strong performance, in a $52 a barrel oil (Brent) price environment, which should please investors. Now, the oil giant looks well positioned to generate even higher levels of free cash flows in the future, thanks to further improvement in oil prices. The commodity has risen to almost $61 a barrel, its highest level in over two years. The strength is being fueled partly by expectations that OPEC and its allies, including Russia, will extend their agreement to limit oil supplies. The cartel and its partners originally agreed to curb output by 1.8 million barrels per day through March 2018, but the Saudi Arabia’s Crown Prince Muhammad bin Salman and Russia’s President Vladimir Putin have backed the extension of the deal beyond the first quarter of next year.

In addition to this, the oil market’s supply-demand fundamentals are also improving. The crude oil stocks in the OECD nations have fallen by 178 million barrels this year and are moving closer to the five-year average. In the US, production growth will likely slow down as operators are focusing on living within cash flows. The ongoing unrest in Iraq has also disrupted supplies from one of the world’s largest oil producers. Meanwhile, the oil demand is coming in stronger than expected, which is likely due to the underlying strength of the global economy. Demand from China, in particular, is growing. The country recently became the world’s top oil importer, surpassing the US, when its purchases hit 37 million tonnes, or 9 million barrels per day, in September.

In this backdrop, if OPEC and its partners officially extend the production freeze agreement, then that could further bolster oil prices. That could give a significant boost to Shell’s earnings and cash flows. Remember, Shell has said that every $10 per barrel improvement in oil prices can lift Shell’s profits by roughly $10 billion on an annualized basis. This means that theoretically, if oil holds its ground at $60 a barrel, then it could fuel double-digit growth in Shell’s profits. This will be accompanied by strong growth in cash flows as well. The company has previously said that at $60 oil, it can generate $20 to $25 billion of organic free cash flows in a year.

In short, the improvement in oil prices to $60 a barrel can give a significant boost to Shell’s earnings and free cash flows. That should have a positive impact on Shell stock. The company can then create further value for shareholders by using the excess cash to reduce debt in order to bring its leverage ratio down to its target of 20% or increase dividends. Shell normally trades at a discount to Exxon Mobil and Chevron who have superior balance sheets. Currently, Shell’s shares are trading 15.8x next year’s earnings estimates while its US-based peers are priced more than 21x. But I believe the reduction in debt or increase in dividends can give a boost to Shell’s valuation.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: I own shares of funds that may hold a long position in Royal Dutch Shell and Exxon Mobil.

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