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Royal Dutch Shell: The Turnaround Will Continue

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screen-shot-2016-10-06-at-13-11-55Alpha Investor: 12 October 2016

Summary

Royal Dutch Shell shares have received a boost in the past month on the back of an improvement in oil prices, a trend that is likely to continue.

There was excess oil demand of 500,000 bpd in the third quarter as against supply due to production cuts across the globe and robust demand, leading to an inventory correction.

Oil prices will rise further as Saudi Arabia, Russia, and the U.S. are all intent on reducing the industry oversupply, which will lead to further inventory declines.

Shell is well-placed to capture the upside in oil pricing due to its deepwater prospects, which will hit break-even in an oil price range of $30-45 per barrel.

Overall, Shell believes that its developments in the deepwater will be able to remain profitable even at an oil price of $45/barrel, which is good news for investors.

Over the past month, Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has been in turnaround mode on the market. In fact, after losing value over the past quarter, Shell shares have clawed back around 3% of their market capitalization in the past month. This rally in Shell shares has been driven by the recent resurgence in the crude oil price. Looking ahead, I believe that Shell shares will be able to sustain the rally due to two reasons – an improving oil price environment and the efficiency of its upstream business.

In this article, we will take a closer look at both these points.

Expect further improvement in oil prices going forward

Toward the beginning of August, Brent oil was trading at just $42/barrel. But now, Brent oil is trading slightly under $53/barrel. Thus, in a span of just over two months, there has been a massive improvement in oil prices and this is the reason why Royal Dutch Shell shares have received a boost. Looking ahead, further improvement in oil prices due to improving demand and lower supply will allow Shell to continue improving its performance.

For instance, one of the key reasons behind the rise in oil prices of late is the decision undertaken by OPEC nations to lower the output in a range of 1-2%, with Saudi Arabia itself slashing output by 400,000 bpd. Additionally, even Russia has decided to join OPEC in its efforts to reduce oversupply in the end-market.

The expected production cuts by Saudi Arabia and Russia indicates that the world’s top three oil producers, including the U.S., have been focused on reducing production to support oil prices. I’m saying this because oil inventories in the U.S. have been on the decline for the past five consecutive weeks. In fact, for the week ending September 30, U.S. oil inventories were down by 3 million barrels.

This decline in inventories in the U.S. is not surprising since the country’s oil production will go down by 600,000 bpd this year, followed by another 300,000 bpd next year. As a result, there will be a reduction in oil inventories. In fact, due to a reduction in production of late, there was excess oil demand to the tune of 500,000 bpd in the third quarter as against supply, which bodes well for oil prices.

Now, as demand for oil is set to improve both this year and next year, and supply declines simultaneously, the price should continue to rise on the back of an inventory correction. The following chart shows the inventory correction in the oil market:

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Now, as the price of oil continues to improve going forward, Royal Dutch Shell will be in a strong position to take advantage of the improvement in the price of the commodity. This is because the company has reduced the cost structure in the upstream business as discussed below.

Lower upstream costs will be a tailwind

Shell has remained focused on enhancing its productivity in a difficult oil pricing environment and keep costs low at the same time. This is the reason why the company has been focusing more on exploring its deepwater prospects as costs in this area are declining while production is increasing.

More specifically, Shell has been able to bring down its drilling time in the Gulf of Mexico to the tune of 30%, which has led to a 40% drop in drilling costs since 2014. Along with a reduction in these operational costs, Shell has also reduced the application of capital expenditure in the offshore, which has helped the company bring down its break-even point on each barrel of oil equivalent. This can be seen in the chart given below:

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As seen above, the majority of Shell’s deepwater prospects will hit break-even in an oil price range of $30-45 per barrel. This is good news for investors since the company will continue to increase production from the deep water, which will allow it to improve its financial performance going forward due to low costs of production. Overall, Shell believes that its developments in the deepwater will be able to remain profitable even at an oil price of $45/barrel, indicating that they are currently getting profitable as the prices have picked up.

Conclusion

Hence, Royal Dutch Shell is moving in the right direction in order to improve profitability even in a low oil pricing environment. So, in my opinion, it will be a good idea to remain invested in Shell shares as the company is capable of sustaining the momentum that it has gained of late.

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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