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Shell Set To Play A Major Role In The Global Gas Market

Zoltan Ban: Aug. 3, 2017 6:55 PM ET


– Shell profits down compared with the previous quarter, which is in part a reflection of the lower oil prices.

– While the shorter-term results were affected by the falling oil price, the long term strategy of becoming a leading and dominant player in LNG remains intact.

– Global energy trends continue to suggest that LNG is a good long-term bet, given economic as well as environmental considerations.

While Shell (RDS.A) did report a second quarter net operating profit of $1.55 billion compared with $3.5 billion in the previous quarter, it should be noted that when looking at the different sectors, it is the downstream segment which has been helping it stay above water this year. The upstream segment seems to be struggling within the context of the current oil & gas price environment, same as we can expect the global oil & gas industry to do overall.

Shell’s upstream segment took an operating earnings hit of $544 million for the quarter, while its downstream operations achieved net operating earnings of $2.16 billion. This shows just how important it is this day and age for an oil & gas company to be well-diversified. It may seem like a drag when oil prices move much higher, making it seem like the downstream segment acts like a huge impediment on profitability gains, but as we know, the oil market tends to be very volatile, which is why being a well-diversified company provides for an effective hedge against that volatility.

In fact, it is more than a hedge, because as we can see, it does more than just minimize losses. It can actually lead to a profit during what may be considered hard times for the industry. In this regard, we have to continue to appreciate Shell’s continued efforts to add value-added operations to complement its upstream efforts.

Despite oil prices being about 8% lower on average compared with the previous quarter, Shell managed to limit its decline in revenue from $73.3 billion, to $72.7 billion quarter on quarter, which is where the benefit of being more diversified becomes evident. Year on year revenue increased by $12.5 billion, or almost 21%. That, of course, is in large part the result of the BG merger. One of the important resulting effects of the merger was a 13% quarterly increase in LNG sales, from 14.25 million tonnes to 16.1 million tonnes year on year. Dominance of the global LNG market seems to be one of the big long-term strategies of Shell. It is a strategy I happen to agree with, which is in large part why I invested in its stock.

As we have heard lately, the Paris accord brought together a large number of major pledges to reduce or at least contain the growth in greenhouse gas emissions. Due to the nature of our society, which tends to result in political rhetoric of a certain flavor and the mass-media, which tends to trend towards the idealistic, our collective minds automatically tend to produce a vision of solar panels and windmills when we hear of any plans to reduce emissions. It is how we believe Europe managed to keep its emissions under 1990 levels. While it is certainly true that renewable sources such as wind & solar played a significant role in curbing emissions, the one factor that I keep pointing out, but other than that it is not generally talked about too often, is the large substitution of coal with natural gas which took place since 1990.

Source: SA article on Paris Climate Accord.

As we can see, Europe increased its natural gas demand by about 6 Tcf from 1990 to 2008, which is a roughly 45% increase. The data I used from the EIA has been discontinued since I produced this graph, making it hard to update the data, given that it tends to be incompatible from one source to another, but it is nevertheless useful to look at the data we do have, which clearly shows the substitution happening.

Recent data shows that there is now a resumption of relatively robust natural gas demand growth in Europe. The 2008-2013 decline we see in the graph is in large part due to the five-year economic slump the EU suffered, starting from 2008. Another way to explain this trend and get a glimpse at what is happening more recently is to look at Gazprom’s exports to Europe from 1990 till the present, which reached a new record high last year.

Data Source: Gazprom.

As we can see, the fortunes of Gazprom and its exports to Europe keep improving together with Europe’s improvements on emissions. Some of the recent gains in exports to Europe also have to do with recent declines in domestic European natural gas production, but that is only part of the story. Continued efforts made by Europe to further cut emissions in coming years is leading to a renewed interest in increasing gas imports from Russia.

But as we well know, Russian gas imports do have a political aspect, which makes this continued increase on Russian dependency politically sensitive, which is why I think Europe will see increased LNG demand going forward, with some forecasts out there expecting as much as a doubling in demand by 2020, compared with 2015 levels. I personally do not think that the increase in LNG demand will be as robust in Europe as expected by some forecasters. I do believe that there will be a significant increase, but I also think that Russian exports will continue to increase as well, cutting into some of the expected gains in LNG sales to the old continent.

Europe model on emissions to be exported elsewhere

We do not have to go much further than the US domestic record on emissions to realize the massive positive effect that large-scale adoption of substitution of coal with natural gas can have on emissions reduction. US emissions have been on a steady decline path for a decade now, which largely coincides with the shale gas boom, which brought prices down and thus caused an increase in gas-powered electricity production, to the detriment of coal.

Source: EPA.

In the US, the determining factor which led to the switch from coal to gas for electricity generation was the price. In other parts of the world, especially in Asia, I expect that environmental considerations will prevail, not so much because they will feel the need to adhere to the commitments made in Paris, but because there are some very real and immediate concerns in regards to general public health as well as environmental degradation.

While I do not really believe that countries like India, China and many other fast-growing economies around the world care very deeply about meeting the Paris pledges, which are voluntary and unenforceable, not to mention in their particular case, less than impressive, I do think that these countries are starting to realize the limits to using cheap coal as a means to achieving industrialization. China came to realize this a few years back as health effects on its population became apparent and undeniable, leading it to put the brakes on coal demand expansion, leading to the two consecutive years of global demand decline, with this year possibly being the third year in a row.

The limiting factor is not a concern for the world’s climate, but rather concern for the health of their citizens, which happens to be a much more effective stimulant for action than broader, collective, global good concepts. For this reason, I believe that the region of Asia is likely to emulate Europe’s shift away from coal and towards more reliance towards natural gas. Wind & solar will, of course, continue to dominate the headlines, while the larger fossil fuel trend will fly under the radar, as it is just not all that trendy socially and ideologically speaking.

I do not believe we will see the kind of coal demand drop in Asia like we saw in Europe. In fact, we will most likely not see any demand decline at all between now and a decade from now. Natural gas will nevertheless be used by most countries in the region, which are enjoying relatively robust economic and industrial growth as a way to dampen demand growth for coal.

Source: BP.

There is not a great deal of natural gas consumption in the region that comprises about half of the world’s GDP in PPP terms. India & China, in particular, are well behind in this regard, compared with most other major global economies. These two countries consume together, less than one-third of what the US consumes, despite having almost ten times more people between the two and a combined nominal GDP that is about the same size. In effect, each and every Chinese & Indian resident currently consumes on average about 50-60 times less natural gas than the average American.

In terms of coal, though, these same two countries consume roughly six times more than the US. While India is forecast to experience relatively robust coal demand growth going forward and even China is forecast to reverse it coal consumption decline trend and start increasing its demand for it again, I doubt that they will want to return to the era of over-reliance on it in order to satisfy their growing demand. Wind & solar will, of course, be trumpeted as the main alternatives, but gas will satisfy the largest proportion of this entire region’s growing energy appetite, with renewable and other sources playing a significantly smaller role.

While I do expect most natural gas supply increase in the Asia-Pacific region to happen as a result of a number of new pipelines either currently under construction, or in planning stages, LNG will have to play a significant role in not only supplying the market but also in providing it with increased flexibility and stability. I continue to believe that natural gas will play a much bigger role in the global energy future than is currently being contemplated, and within that context, LNG will play an even bigger role proportionally speaking. In this regard, there are few better options among oil majors than Shell if one wants to participate in the LNG story, without resorting to making a much riskier bet, such as buying a pure LNG name like Cheniere (LNG), for instance.

Shell is set to produce about 12% of the world’s LNG supply this year, based on volumes we have seen this year so far. Its natural gas sector, which includes LNG has been overall profitable, with $1.2 billion in net operating earnings in Q2. I think its natural gas related operations are particularly well-positioned to take advantage of what I see as a global effort to cut reliance on coal in favor of cleaner energy sources, with natural gas not being the most glamorous, but certainly seems to be the most practical and popular option. Within this context, Shell is set to play a major and arguably dominant role in providing the global gas market with supply flexibility, which is going to be an indispensable service as natural gas takes up an ever larger chunk of the global energy market.

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

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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