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Shell: Executing On Its Plan But No Upside In The Stock Price

By : May 31, 2017

Royal Dutch Shell (RDS.A, RDS.B) suffered a dramatic drop in earnings and cash flow in 2015 and 2016, as crude oil prices fell from about $100 per barrel to about $50 barrel in the second half of 2014.

From $14.7 billion earnings in 2014, Shell’s earnings fell to $2.2 billion for 2015 and $4.8 billion in 2016. In response, Shell embarked on a strategic transformation of their entire company, of which the key cornerstones were:

  • Completion of the acquisition of BG;
  • Divestment of in assets;
  • Bringing new production online for ongoing projects;
  • Realizing operating cost reductions; and
  • Reducing debt.

My analysis of their financials show that while they are on track to achieve their plan, investors should not expect dividend increases through 2020. In this article, I will review the impact of the divestments on the balance sheet and the required run-rate free cash flow that Shell will need to deliver on its financial strategy. I conclude that the dividends are safe, but share price appreciation will be limited.

Background and Summary of Shell’s Current Strategy

From 2011 to 2014, oil prices were mostly over $100 per barrel, which led to enormous profitability of upstream major oil companies like Shell. During this time, there was a view that growing demand for transportation fuels from rapidly developing countries, primarily China and India, was intersecting with more costly incremental supplies of oil from deepwater offshore, arctic, and Canadian bitumen sources.

However, the big turn came in 2014 when it became apparent that increased supplies of oil from the United States’ shale plays were here to stay. U.S. oil production increased from roughly 6 million bpd in early 2012 to 8.5 million bpd in middle of 2014. In addition to adding significant new supplies, these new shale plays were being added at lower breakeven costs that what the market had been estimating as costs for new deepwater offshore, arctic, and bitumen plays.

The market result of the shift in thinking about the marginal cost of new oil supplies was the dramatic fall in oil prices from $100 to $50 a barrel in the second half of 2014 (see graph below). By 2016, it was apparent to the market that this was not a temporary cycle in crude prices, but was a fundamental shifting of the oil market. As a result, the oil majors, including Shell, started to rethink their fundamental strategy.

Shell unveiled their new strategy at their Capital Markets Day in June 2016. The full presentation is here, but key message of their strategy is on the fourth slide:

The messaging at their 2016 Capital Markets Day was clear. Shell was acknowledging that they needed to focus on producing cash now, rather than just selling long-term growth stories, that they needed to reduce production and overhead costs, and that they needed to reduce debt. In terms of key financial goals they outlined 2019-21, these include:

  • Targeting $20 to $30 billion per year free cash flow (FCF), while maintaining capital investment (CFFI) of $25-30 bn. This would result in a target of $45 to $60 bn in cash flow from operations (CFFO).
  • Integrating BG and delivering $4.5 billion in synergies with targeted run-rate operating costs of $40 bn.
  • Divesting $30 billion in assets.
  • Delivering this performance in a $60/bbl price environment, with about $5 bn of sensitivity to each $10/bbl change in price.

Scoring Shell’s Performance Vs. Plan and Free Cash Flow Forecast to 2020

Shell held their Q1 conference call on May 4. On the call, CFO Jessica Uhl confirmed they were on target for achieving the $40 billion run-rate for operating costs by 2017, that $15.7 billion in divestments have been announced for 2017, on top of the $4.7 billion in 2016. In addition to the these goals, which are followups to the 2016 Capital Markets Day, there were two additions including:

turning of the Scrip, and

get the debt and the gearing down to some 20%.

These two statements are important additions because they have an impact on the cash flow forecasts. First, we explain what these mean. On the comment about the “scrip,” this refers to an option that Shell offers it shareholders where both A and B shareholders can receive shares of RDS-A for dividends instead of cash. Last year, about one-third of the dividend entitlements were paid in shares, resulting in an approximate 2.3% dilution of the common shares. The dividends paid in cash last year was about $9.7 billion, but the scrip payments were about $5.3 billion. Therefore, if the scrip were eliminated, the additional allocation of FCF to dividend payments would be more than $5 billion.

Second, on the debt gearing, Shell is targeting to have ratio of debt to total assets and liabilities of 20%. Currently they are at about 27% gearing with net debts of $72 billion, which means that they will need to reduce debt by about $20 billion to achieve this target.

To quantify what this means for their cash going forward, I have reproduced their actual CFFO, CFFI, FCF, divestments, and dividends for 2014-16. From the 2016 baseline, I have increased their CFFO based on their projections of $10 billion additions from new projects coming onstream by 2018, the cash required to eliminate the scrip, and the cash to get their debt gearing to 20%. That forecast is below.

Source: Shell 2016 Form 20-F and author’s calculations

In this forecast, CFFO will grow to $38 to $40 billion for 2018 to 2020. With capital expenditures of $25 billion, which is the lower end of their Capital Markets Day projections and reiterated during the Q1 call, this leaves FCF of $13 to $15 bn a year. The cost of the dividend, after elimination of the Scrip is $15.7 billion a year, due to the increase in the number of shares in 2016 and 2017 from roughly 2.3% dilution per year from the new issuance under the scrip program.

Finally, the divestment proceeds are roughly used to cancel out the $20 billion debt reduction target they have. The net result of this shows that Shell’s cash flow projections are credible, they can hit their capital spending targets while reaching debt reduction and elimination of the scrip program.

However, there is no room for error, as my forecast shows no spare FCF. As these projections were based on Shell’s $60/bbl oil price scenario’s, at today’s forward curve of about $53/bbl, there could be $3.5 billion a year shortfall in these projections.

Summary and Investment Thesis

After the dramatic fall in oil prices in 2014, Shell reassessed its strategy. Key elements of its strategy included completing the BG acquisition, divesting $30 billion in assets, reducing operating costs, reducing capital expenditures, reducing debt and stopping shareholder dilution by turning off the scrip.

My forecast of cash flows through 2020 shows that they have a credible case of achieving all of these goals, but there is no margin for error at current crude oil prices. For dividend investors, it appears as if the dividend is safe as they are delivering on all the elements of the plan to produce the FCF to support the dividend, especially if the scrip program is continued.

However, for total-return investors, share price appreciation will be suppressed until it is clear that there is more headroom on free cash flow. The current forecast shows Shell can just maintain its dividend after successful execution of its stated strategy leaving no free cash flow for growth. Shell has likely squeezed operating costs as much as they can, so future significant FCF headroom gains will need to come from increased gross margin production, which will require either higher crude oil prices, or new strategic acquisitions.

Disclosure: I am/we are long RDS.B.

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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