Shell Prepares For A Different Energy Reality

This summer has been filled with the sort of headlines that can give strategic planners in the petroleum & gas sector heartburn. One-upping Germany’s earlier non-binding pledge to ban new internal combustion engine [ICE] vehicles by 2030, the government of France’s new centrist president Emmanuel Macron announced in early July that the country will end sales of ICE vehicles by 2040. This move, which is part of that country’s efforts to comply with its greenhouse gas emission reduction target under 2015’s Paris Climate Agreement, would eliminate gasoline- and diesel-only engines and is aimed at reducing the country’s air pollution as it is at mitigating climate change. Britain intends to do the same by 2050. Even China and India, which have long been posited as important future sources of petroleum demand, are moving to electrify their vehicle fleets: China recently announced that it wants 25% of the country’s vehicles to be “alternative fuel” by 2025, while India is drafting plans to electrify all of its vehicles by 2030.

Against this backdrop come a number of summertime moves by petroleum & gas major Royal Dutch Shell (RDS.A)(RDS.B) to diversify its holdings in a way rarely seen by the industry since energy prices collapsed in late 2008. The multinational firm joined industry peers such as BP (BP), Total (TOT), and ExxonMobil (XOM) in June as a founding member of the Climate Leadership Council, which unsuccessfully advocated for the U.S. to remain in the Paris Agreement. Shell itself has engaged in a number of recent maneuvers that are not as immediately self-serving (multinational firms with large exposure to the U.S. market have a strong incentive to see that market avoid the imposition of carbon tariffs or other punitive measures by its trading partners in the developed world) as the Council, however.

Late last month Reuters reported that Shell was among several firms interested in bidding for Singapore-based renewable energy producer Equis Energy. Earlier this month the company did invest in the Singapore solar firm Sunseap, which has 0.16 gigawatts [GW] of distributed solar PV contracts and is raising $55 million for new utility-scale renewable energy projects in Southeast Asia. This amount is inconsequential for a firm the size of Shell, however, which is what makes the Equis Energy report notable: the latter firm is estimated to be worth up to $5 billion, and it has a diversified portfolio of wind, solar, and hydroelectric projects totaling 4.4 GW with another 6.7 GW under development.

Also, in a small but potentially far-reaching investment, Shell also announced last month that it has acquired exclusive development and licensing rights for the biofuels technology developed by Canadian firm SBI BioEnergy. What makes this technology unique is that it produces a fuel that is “carbon negative” in that its use results in the net sequestration of CO2 from the atmosphere at a time when climate scientists believe that catastrophic climate change will only be averted via net sequestration (even aggressive deployment of zero-carbon pathways only postpones the inevitable at this point). Specifically, whereas conventional petroleum roughly has a net positive carbon footprint of 92 grams CO2 per megajoule of energy (this of course varies according to extraction and processing requirements), fuel produced by SBI BioEnergy’s pathway has a net footprint of -14 grams CO2 per megajoule energy. It should be noted that this is not a widespread solution to the problem of climate change since the net negative result is a function of the pathway’s energy efficiency, its use of waste feedstocks that would otherwise decompose to CO2 and CH4, and its ability to displace other energy sources. However, its ability to produce products such as diesel fuel and jet fuel that are at little risk of being displaced by batteries in the intermediate-term make it of special interest to a firm such as Shell.

This interest in global renewable energy projects reflects a belief by Shell’s management that sets it apart from many of its peers such as BP, specifically that “peak petroleum demand” will be a reality worldwide sooner rather than later. CEO Ben van Beurden stated this summer that the company expects global consumption to begin declining by the end of the 2020s, reversing a trend that has more or less existed since the dawn of the internal combustion engine, and certainly since the early 1980s (see figure). While this is not the first time that such a projection has been made (similar forecasts were widespread when the price of petroleum hit $150/bbl in 2008), it is the first time that I can recall an oil major saying so at a time when prices are under $50/bbl. Indeed, Mr. van Beurden also stated this summer that the company is focused on being “fit for the forties” in anticipation that long-term prices will remain below $50/bbl.

Shell’s forecast of a low-price, low-demand environment is based on the expectation that peak demand will be caused by the increased electrification of the transportation sector as additional countries take steps similar to those outlined above by France, Germany, China, and India. The company’s response to this forecast is to diversify into broader energy holdings as opposed to just petroleum and natural gas. That is not to say that it is exiting its historical business, of course: Mr. van Beurden told investors to expect continued investments in petroleum reserves in the near-term to meet demand growth over that period. Rather, it is expanding into areas that are expected to experience long-term demand growth under the Paris Agreement that are also synergistic with its historical operations.

Natural gas continues to be a critical backstop to wind and solar PV (as well as hydro to a lesser extent) and will remain so until major advances in utility-scale battery technology are made (if ever). As a result, Shell expects natural gas demand to continue growing at 2% annually through at least 2030 and LNG demand to grow at twice that rate over the same period. Natural gas consumption can be expected to increase rather than decrease as renewable electricity capacity expands globally. Likewise, the displacement of gasoline by electricity could result in the undersupply of other refined fuels and commodity chemicals that will likely be met by natural gas and biomass feedstocks instead. Shell’s July announcement that it plans to spend $1 billion annually on clean energy investments in its New Energies division must be viewed within this context. Rather than being a form of “greenwashing” in which a company engages in token “clean energy” investments as a means of distracting observers from its primary “dirty energy” activities, Shell’s strategy appears to be focused on true diversification within what it expects to be its future operating environment.

Investors and regulators alike should take note. Shell’s activities have taken place at a time when one of its largest peers, ExxonMobil, is defending itself from allegations by New York Attorney General Eric Schneiderman that it “defrauded” investors first by covering up its research into the impact of fossil fuels on climate change (it did not) and then by overstating the value of its petroleum reserves within a future “carbon-constrained” world. The investigation is viewed by much of the investment arena as a potential precedent-setter for future investigations into other petroleum & gas majors. Shell’s management is demonstrating that how a firm adapts to its expected operating environment is a function of its expert forecasts rather than a matter of historical fact despite the latter being claimed by Mr. Schneiderman. The role of investors is to determine which forecast they expect will result in the largest returns. If ExxonMobil is overstating the value of its reserves under future climate policy conditions then the company and its investors will be punished by the market in the form of a reduced market capitalization, whereas Shell and its investors will likewise benefit. Of course, the opposite result is also possible, especially if policymakers fail to fully internalize the external costs imposed by CO2 emissions. It is the place of the market to determine which scenario is correct in the end, and to attribute awards and penalties accordingly. In the meantime, Shell’s management is making a well-argued case that the scenario that it envisions will ultimately be deemed the correct (and most profitable) one.

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 am long XLE.