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Why $55 Brent Is Big News For Shell

: Sept 21, 2017

Summary

  • Checking out high-yielding Royal Dutch Shell plc.
  • Brent bouncing up to over $55/barrel is big news that I think has been under-reported in the financial media.
  • Overview of Shell’s finances and significance of higher Brent prices.

In light of material increases in realized upstream prices and an improving downstream sector, Royal Dutch Shell plc’s (NYSE:RDS.A) (NYSE:RDS.B) financials have shown tremendous improvement this year. The worst of the downturn is behind the oil sector, but keep in mind crude prices remain range-bound. That being said, with Brent (global oil benchmark) back over $55/barrel (high end of the range), things are looking brighter and brighter for Royal Dutch Shell every day. Especially when it comes to fully covering Royal Dutch Shell plc Class A and Class B shares’ lofty 6+% yields. Let’s dig in.

When I start a new series on an oil & gas company, I like to first provide a review of its finances to set the tone of what investors should expect. Growth projects and future plans for value creation are all good and well, but that needs to be compared and contrasted with Royal Dutch Shell plc’s current financial situation.

Earnings overview

If you have already been following Shell over the past few years, you may want to skim over this section, but if you haven’t been, this is key information to note as it sets the stage for what I’m getting at.

On an adjusted basis, Shell posted $3.6 billion in net income in Q2 2017, down slightly from $3.8 billion in Q1 due to weaker upstream realizations. However, 1H 2017 earnings were up to $7.4 billion versus $2.6 billion in 1H 2016, a very strong turnaround albeit one off of a very low base.

Investors should note that the adjustments include CCS accounting for its downstream division (reflects changes in commodity prices to provide a better comparison) and don’t include certain corporate level expenses (presumably because they are one-off events, but I would caution that this adjustment can be a tad generous at times).

Downstream (includes petrochemical, refinery & marketing/retail, and trading operations) and Shell’s integrated gas (includes liquefied natural gas and gas-to-liquids operations) division helped keep the energy giant above water during the downturn. While Shell’s upstream division lost almost $3 billion in 1H 2016, its integrated gas division posted almost $1.9 billion in income and its downstream division generated $3.8 billion in earnings (all earnings figures are adjusted). However, it became clear during the bust that weak realizations drag everything down.

Shell’s average liquids (mostly oil) realizations came in at $35/barrel in 1H 2016, down by $11/barrel versus its 2015 average ($46/barrel) which in turn has half of what it was realizing in 2014 ($90/barrel). On the gas front, Shell went from realizing $6.66/Mcf in 2014 to $4.85/Mcf in 2015 to $3.55/Mcf in 1H 2016. Downstream crack spreads were mixed over that time frame (2015 was a banner year for Shell).

When Shell’s 1H 2017 liquids realizations shot up to $47/barrel, its gas realizations jumped to $4.26/Mcf, and in most instances its crack spreads improved, and its finances immediately showed serious improvement. During the first half of this year, Shell’s adjusted income from its upstream division became positive at $879 million, its integrated gas division posted $2.35 billion in earnings, and its downstream assets churned out just over $5 billion in profit. Corporate expenses ($670 million) and non-controlling interests ($219 million) took that down a tad.

The important thing to take away is that Shell’s finances are improving on all fronts. Sure, Q3 saw global oil prices continue moving lower for most of the quarter so Shell’s next earnings report will probably be lackluster, but Brent is now back over $55/barrel heading into Q4.

Brent over $55

One of the most under-reported things in the financial media is that Brent has been on an aggressive upward movement. Over the past three months, Brent has rallied by about $10, equal to a 22% jump. This major development was lost due to WTI (America’s oil benchmark) not doing as well relatively speaking, at least in my view.

Brent at $56 heading into Q4 is a big deal. During 1H, Brent averaged $51.67 with the best quarter coming in Q1 when it averaged $53.69. As of this writing, Brent sits at $56.29, a material improvement that if held will do a lot of good for Shell’s Q4 results.

Global gas prices, including spot LNG prices and LNG realizations through long-term contracts, are linked to Brent, so this is much more than just higher oil & condensate realizations. Stronger performance at its integrated gas and upstream division, complemented by continued strong downstream performance, will really give Shell the jolt investors have been waiting three years for. Brent is looking its best since 2017 began and that is something investors should truly take to heart.

Now in order to capitalize on this, upstream players need a significant international footprint like Royal Dutch Shell. Sure, America can now export crude oil but that has its limitations. Really, American upstream firms need access to prices in the Gulf of Mexico (like Louisiana Light Sweet) or the West Coast (Alaska North Slope) to get prices closer to Brent. ANS and LLS are currently priced at a buck or two below Brent, which is several bucks higher than WTI.

In regards to WTI, while it has rallied about 18% over the past three months and is back up to $50.41 as of this writing, that is lower than where WTI was trading in Q1 ($51.70 average) and is roughly on par with its 1H average of $49.91. While WTI is in a much better place than where it was entering Q3, it is basically back to where it started this year at.

However, Shell has a large presence in the Gulf of Mexico and its light sweet oil production in the region will benefit from higher Brent prices through LLS realizations. Its remaining oil sands division, the liquids side of its Appalachian division, and crude produced in the Gulf of Mexico that isn’t a light sweet oil type will not.

The impact of Hurricane Harvey is hard to gauge, but I would speculate that due to repair related costs and Shell’s material upstream, midstream, and downstream presence in the Gulf of Mexico, it was a net negative that will be reflected in its Q3 results and wear off by the time Q4 starts.

Cash flow picture

Shell generated $20.4 billion in operating cash flow (excluding working capital effects) in 1H 2017. The energy giant also pocketed $6.8 billion in proceeds, but I don’t consider that a reoccurring event even though Shell is actively pursuing an expansive divestment program (additional divestment proceeds will come in during 2H).

Royal Dutch Shell spent $10 billion on capital expenditures, $0.35 billion on JV investments, $5.6 billion on dividends to Shell shareholders, $1.7 billion on net interest expenses (not reflected in op cash flow), $0.2 billion on dividends to non-controlling interests, and $0.25 billion on other investing uses of cash flow in 1H 2017. Equal to $18.1 billion in “organic” expenditures.

Most importantly, Shell was covering its cash flow spend organically during the first half of this year. Now I will caution that its cash dividend expenses were reduced due to its scrip dividend (investors opting for shares instead of cash) introduced at the beginning of 2015 and that its 2017 capex budget calls for $25 billion in expenditures, implying a higher spend in 2H to the tune of $2.5 billion a quarter. On the dividend front, eventually the dilution will need to end which will drive cash outlays higher. After debt reduction ending the scrip dividend is a top priority, but Shell needs energy prices to cooperate.

Keeping that in mind, Shell’s cash flow generation should really perk up in Q4 and into 2018 assuming Brent holds its current level. While the company generated FCF in 1H, weak upstream prices and its higher capex spend may change that in Q3. By Q4 free cash flow generation becomes likely, noting that the scrip dividend does make this objective much easier.

Also key is the oil sands development, which was completed on May 31. Prices for crude coming out of Alberta, even oil that has been upgraded to a lighter sweeter crude type (oil sands produce heavy sour crude that can be upgraded), are terrible and trade at a massive discount to WTI. In light of the high cash operating costs oil sands developments have, these ventures need ~$40-45 WTI just to break even on a cash basis. Due to the inability to export a material amount of oil sands produced crude to non-US markets, the rise in Brent doesn’t come into play.

When you include non-cash costs like DD&A expenses, which are quite high, these endeavors just aren’t profitable in the current oil market paradigm. So by shedding most of its oil sands assets, Shell materially reduced its underlying cost structure. While its cash flow generation may marginally be impacted (wasn’t generating much to begin with), its income generation will improve materially as losses from its upstream North American division have been a major drag on earnings.

Final thoughts

Bullish OPEC rumors (most likely an additional supply cut won’t happen, but an extension is very likely in my view), several weeks of proof that America’s rig count is stabilizing (don’t get me wrong, drilling activities and completion activities are two different beasts, but this is still important), stronger-than-expected demand growth (2H demand growth is solid and a growing body of analysts are expecting 2018 demand growth to be better than expected) and continued drawdowns of record high petroleum product and crude oil stockpiles paint a favorable picture going forward.

Not so favorable that it’s guaranteed a sustained recovery is underway, keep in mind the Libya, Nigeria, and OPEC/non-OPEC compliance wildcards are still at play, but the macro picture is improving which bodes well for oil prices. Royal Dutch Shell should do just fine in a sustained $55 Brent world, especially as divestment proceeds are being deployed to bring down its debt load. With Royal Dutch Shell’s Class A shares yielding 6.4% and Class B shares yielding 6.2%, this is a very interesting name that I’m taking a much closer look at.

Investors interested in reading about Royal Dutch Shell’s midstream spin-off Shell Midstream Partners LP (NYSE:SHLX) should check out this article here.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RDS.A, RDS.B over 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

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