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Royal Dutch Shell: This Is Another Catalyst

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Jun. 30, 2016 4:35 PM ET

Summary

  • Royal Dutch Shell witnessed weakness in the downstream segment last quarter due to lower refining margins, but this is about to change going forward.
  • There has been a rapid recovery in the refining marker margins, which has increased from around $9 a barrel to almost $17 a barrel within a short time.
  • Shell’s downstream performance will improve as refining margins in the second quarter averaged higher than the first quarter, with more upside expected going forward.
  • Driven by higher gasoline consumption and increasing utilization rates, refining margins will increase in the long run and act as a tailwind for Shell.
  • Shell’s structural improvements in the downstream, such as refinery integration in Louisiana, will allow it to lower costs and tap the end-market demand in a better manner.

In a recent article on Royal Dutch Shell (RDS.A, RDS.B), I had focused on how an improvement in the upstream business will bring about a recovery in the company’s overall financial performance. The upstream business was under a lot of pressure in the first quarter, and a rally in oil prices over the past few months will ease the pressure on the same as oil price realizations improve.

But, being an integrated oil and gas company, Shell’s performance will also be driven by its downstream segment, which was also under pressure last quarter as refining margins took a tumble. So, in this article, we will see how Shell’s downstream segment has done and how it might do going forward.

Problems in the downstream

The performance of the downstream business is highly-dependent on refining margins. The problem is that from the end of 2015 onward and in the beginning of 2016, refining margins weakened on account of lower gasoline consumption that led to an oversupply in the market. This is shown in the chart below:

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Source: Shell

This drop in refining margins had a negative impact on Shell’s downstream business last quarter as earnings from this segment dropped by almost a fourth on a year-over-year basis. In fact, cost savings of almost $200 million were not enough to mitigate the weakness in earnings from the downstream business due to lower margins. The following chart shows what weakened Shell’s downstream business:

Screen Shot 2016-07-01 at 07.38.08

Hence, it is clearly evident that lower refining margins played a key role in creating weakness in the downstream last quarter. But, the good news is that this is about to change going forward since the scenario in refining has changed for the better this year. Take a look at the chart below for a better understanding:

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As seen above, there has been a rapid recovery in the refining marker margins over the past few months. In fact, the margin has increased from around $9 a barrel to almost $17 a barrel within a short time, with margins in the second quarter of the year averaging higher than the first quarter. This will prove to be a tailwind for Shell going forward as the earnings of its downstream business will pick up pace in the current quarter on the back of higher refining margins.

More importantly, I believe that Shell will continue to witness growth in the refining business going forward that will help it strengthen the downstream business further. Let’s see why.

Why downstream is set to get better

The prospects of the refining business will continue to improve as the year progresses on account of an increase in the consumption of gasoline. This is because utilization rates are anticipated to pick up pace going forward after completion of the ongoing maintenance activity that was supposed to be completed in the second quarter.

In fact, maintenance activities have led to an outage in refining output, which is why it is anticipated that there will be record refinery runs during the next quarter with an increase of 2.3 million bpd in the refining output. This increase in the refining utilization rate will be driven by an increase in demand for gasoline, which is already rising at an impressive pace.

According to a report by Bloomberg that was released earlier in June, U.S. gasoline consumption will be hitting a record this summer, averaging 9.5 million bpd from April to September. This increase in the U.S. gasoline consumption will be a result of an increase in miles driven as highway travel is set to rise 2.5% in 2016.

More importantly, the trend of robust gasoline consumption will persist next year as well, as shown below:

Screen Shot 2016-07-01 at 07.40.20

Source: Bloomberg

Thus, as the consumption of gasoline rises and utilization rates improve, refining margins will also get better. This will allow Shell to improve its results in the downstream segment, as the company will also be able to take advantage of the structural improvements in the downstream business.

For instance, earlier this year, Shell and Saudi Aramco had decided to split their Motiva joint venture in the downstream segment. Under the terms of this break-up, Shell will be getting two refineries in Louisiana in Norco and Convent. This is a good development for Shell considering that the company has a chemicals plant in the same area. Additionally, Shell also operates its own gas stations in Louisiana, the Northeast U.S., and Florida.

To improve operating efficiencies in this area, Shell has decided to integrate its refinery assets in Louisiana into a single plant with a capacity of 500,000 bpd. Thus, as a result of this move, Shell will be able to save costs due to integration benefits and also tap the growing demand for gasoline.

Conclusion

Hence, Shell should post a stronger performance in the downstream segment going forward as the discussion above suggests. When coupled with the improvements in the upstream business, Shell’s overall performance will get better going forward, which is why investors should continue holding the stock for the long run.

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.

SOURCE

royaldutchshellplc.com and its sister websites royaldutchshellgroup.com, shellenergy.website, shellnazihistory.com, royaldutchshell.website, johndonovan.website, shellnews.net and shell2004.com are all owned by John Donovan. There is also a Wikipedia article.

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