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Shell Swallows BG Group Whole Hog, Rolls Up Cash Flow

Ray Merola: Nov. 6, 2017


  • Shell is enjoying a remarkably successful corporate resurgence.
  • Legacy BG Group opex and capex has been absorbed entirely without a loss of combined hydrocarbon volumes.
  • Cash is king.
  • Debt is trending down.  The dividend is well-covered.  Returns are solid, and improving.
  • I remain constructive on RDS stock.

I’ve been pounding my fist on the table for Royal Dutch Shell (RDS.A) (RDS.B) for a couple of years now. It’s been that one, “fat pitch” worth waiting upon; these don’t come along very often. Since the end of 2015, ADR shares offered investors ~54% total return, or an 80% gain since the stock bottomed in January 2016.

The 3Q report included the hallmarks of recent previous quarters: linked-quarter revenue growth, continued strong cash flow, improving return-on-capital, reduced gearing, steady production, and ample dividend coverage. Details are found here.

The catalysts were the BG Group acquisition, and CEO Ben Van Beurden. The BG deal has proven to be a bonanza. Mr. Van Beurden and his staff successfully guided the integration: stating what they planned to do, then going out and doing it. Coupled with renewed opex and capital discipline, Shell is arguably the strongest Super Major integrated energy company.

In this article, we will illustrate a remarkable achievement: Royal Dutch swallowed the BG Group in its entirety. RDS absorbed all its opex and capex while retaining the hydrocarbon production.

Afterwards, we will benchmark Shell’s current performance versus Super Major peers.

Royal Dutch Shell Remains A Solid Investment

While I believe the easy money’s been made off the cyclical energy lows, I continue to be constructive on the shares, especially for income-oriented investors. The dividend is safe; it’s never really been in jeopardy. The company’s been re-structured to easily cover the payout with $50 oil. Debt is coming down. Major projects are poised to deliver significant, incremental forward cash flow.

Shell Absorbs the Entire BG Group!

In February 2016, Shell completed the acquisition of the BG Group, previously derived from the old British Gas company. The deal was roundly panned by many experts. Royal Dutch believed the transaction supported a strategic pivot to gas and LNG. The closing marked the bottom of the energy commodity collapse.

The BG Group was approximately one-fifth the size of Royal Dutch Shell.

The following tables highlights Shell’s 2015 opex and capex versus the 2017 estimated figures:

2015 figures are actuals, last full year prior to the BG acquisition. 2017 figures are annualized run-rate / forecast by management.

Shell has driven down opex to a $38 billion annualized run-rate from over $41 billion in 2015. Likewise, capex is expected to be drawn down to about $25 billion this year. This includes capital leases carried over from BG. Indeed, meeting this YE capital spending level requires RDS to accelerate work through the fourth quarter.

Furthermore, looking ahead, management does not expect these figures to blow out. Pressure remains upon continued opex control. Near-term, capital is planned to range between a soft floor $25 billion and a $30 billion hard ceiling. Importantly, management is not simply driving down costs. Expectations are for the company to get more bang-for-the-buck for the money it does spend. Far stronger commercial discipline is baked into the current equation than in years’ past.

On the 3Q 2017 conference call, CFO Jessica Uhl commented,

What’s clear is that we continue to drive capital efficiency. What we’re getting for our $25 billion is more than what we would have got for $25 billion one, two, three years ago. That remains a priority for us.

Now let’s look at pre-and-post BG hydrocarbon production volumes, operating cash flow, and prices realized:

2015 figures are actuals, last full year prior to the BG acquisition. 2017 production and prices realized are actuals through 3Q; operating cash flow is annualized.

All 2017 industry regional refining margins are DOWN versus 2015.

Let’s Take A Step Back

Royal Dutch Shell purchased a company about ONE-FIFTH its size.

In two years, OPERATIONAL costs and CAPITAL expenditures are LOWER for the combined entity than immediately BEFORE Shell bought BP. In 3Q 2017, Shell recorded its eleventh consecutive linked-quarter opex reduction. It’s possible some 4Q Downstream expenditures may break this string, but the pattern is set. RDS is serious about expense control.

Meanwhile 2015 versus 2017 oil and gas volumes ROSE 23%. Post-acquisition production jumped 24% in the quarter immediately after the close; in each subsequent quarter, volumes fluctuated not more than approximately 100 thousand boe/d. The steady production profile was maintained DESPITE Shell embarking upon a $30 BILLION ASSET DIVESTMENT PROGRAM. Currently, the 3-year program has yielded $20 billion completed transactions, $2 billion more announced but not yet closed, and greater than $5 billion in process.

2017 OPERATING CASH FLOW is expected to RISE by 28% versus 2015 actuals. Oil and gas prices are not materially better now than those averaged in 2015. Refining margins are lower. Excluding working capital movement, the last 4 quarters’ cash flow attained a $40 billion run-rate.

Comparing Shell With Super Major Peers

Let’s do a quick-check on how Royal Dutch Shell stacks up versus Super Major energy peers. The Super Majors are commonly considered to be ExxonMobil (XOM), Chevron (CVX), BP (BP), and Total (TOT).

There are any number of ways to measure and evaluate these giants. I’ve selected a few simple metrics.

  • 2017 YTD operating cash flow (un-adjusted for working capital movement)

For energy companies, cash flow is a superior metric versus profits.

  • Operating cash flow margin (OCF as a function of total revenue)

This quick measure indicates how much revenue is converted into cash flow.

  • Net debt-to-capital ratio (standardized calculation)

This metric offers a glimpse of about balance sheet strength. Utilizing net debt instead of total debt gives credit to companies holding significant balance sheet cash.

  • Cash return (9 months’ annualized)

A relatively simple but overlooked metric, cash return is measured by taking free cash flow (operating cash less capital expenditures), adding back interest expense (minimizing the underlying capital structure of the company), and dividing the result by enterprise value. Generally, EV is the market cap of the stock, plus debt, less cash. It’s a proxy for what it would take to buyout the entire enterprise. Therefore, cash return is un-levered free cash flow as a function on the value of the entire business.

The ensuing chart captures the aforementioned.

In 2017, Shell generated more cash flow than the other Super Majors. Due to its greater asset base and efficiency, ExxonMobil lead in this category historically. Post-BG, Shell is at the top.

Chevron provides the best OCF margin. Shell and Total are not far behind. BP continues to struggle a bit in a post-Macondo world. While Chevron offers the best margin, the company ranks towards the bottom of the pack on cash return. This reflects higher capital expenditures; having the effect of reducing free cash flow.

Total has the lowest net debt-to-capital ratio. Shell is near the highest. However, Shell has been reducing its gearing aggressively. The BG transaction ran the metric to nearly 30%. Management has stated unambiguously reducing debt is a priority; the gearing objective is 20%. Recently, S&P bumped up the company’s credit rating from “A” to “A+” with a Positive Outlook. The debt trajectory is clear, and it’s going down.

In 2017, Shell investors enjoy the best un-levered free cash return. Other metrics like return-on-capital-employed place Shell in the middle of the pack. Management recognizes this. In 3Q 2017, RDS logged a 4.6% RoCE. The target is 10%. The RoCE trend has been clearly up. If Shell generates a 10% marker successfully, it is very likely to be an industry leader.

Total hydrocarbon production trend is a valuable indicator, too.

As mentioned earlier, post-BG, Shell has maintained consistent, sustained total BoE volumes, despite significant asset-divestitures. New projects filled the gap. Meanwhile, Chevron and Exxon production has been flat. Year-over-year, BP and Total have increased total BoE volumes by 9% and 4%, respectively.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2017 investments.

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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