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Shell Says Yes To Free Cash Flow, No To Debt

Callum Turcan: Nov 15, 2017


  • Royal Dutch Shell generates free cash flow in Q3.
  • Outlook for Q4, even in light of impending capex increase, looks bright due to Brent rallying.
  • Over $10 billion in net debt reduction since the end of Q3 2016.
  • Overview of Q3 results and what to expect going forward.

Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has come a long way since it bottomed out in early-2016. Its latest earnings report reinforced the notion that when Brent is trading in the $50s, Shell’s cash flow position becomes balanced. Cash flow neutrality is the key breakeven point for the industry in the current environment, as oil & gas giants need to show that they can cover capital expenditures and large dividends through organic means at realistic prices. Let’s check out how Royal Dutch Shell did in a low $50s Brent world, with an eye on organic cash inflows and outflows.

Real free cash flow generation

Some digging is usually required to figure out if an oil major is really free cash flow positive or not, largely due to changes in working capital and the need to factor out one-time and inorganic items (such as divestments).

During the second quarter of 2017, Shell generated $11.285 billion in net operating cash flow and posted $1.642 billion in net income. In Q3 2017, while the company posted $4.212 billion in net income, its net operating cash flow came in at only $7.582 billion. However, that is very misleading for one key reason, working capital changes. A $2.258 billion decrease in working capital in Q2 turned in a build in working capital of $2.467 billion in Q3. Non-controlling interest cash outlays are factored into financing cash flow activities and not subtracted from those net income figures.

Adjusting for both working capital changes and interest expenses (Shell adds its net interest expense back to its operating cash flow statements because it factors in cash interest paid as a financing cash flow activity), which came to $757 million in Q2 and $839 million in Q3, Shell generated $8.27 billion (Q2) and $9.21 billion (Q3) in operating cash flow over the past two quarters.

Shell spent $5.05 billion on capital expenditures and contributions to its joint ventures in Q3, on top of paying out $3 billion in dividends to Shell’s shareholders and $0.1 billion to non-controlling interests. Equal to organic cash outlays of $8.15 billion on a quarterly basis, implying the company was truly free cash flow positive during the third quarter of this year. An impressive achievement considering Brent and West Texas Intermediate averaged $52/barrel and $48/barrel in Q3, respectively.

The company also pocketed a tad over $1 billion in asset sale proceeds (from PP&E sales and JV/associate divestments), cash which ultimately will be used for debt reduction if Shell keeps its cash flow situation balanced.

I will caution that shareholders who opted for the scrip dividend (instead of getting cash, shareholders get additional Shell shares) helped make this possible. Shell’s quarterly dividend goes up to $3.875 billion assuming that were instead of be paid in all-cash, or $4 billion per quarter including non-controlling interests. The scrip program started up in 2015 as the downturn took hold.

Q4 outlook

As of this writing, Brent is trading at over $61/barrel and West Texas Intermediate is currently trading around $55/barrel, far above the Q3 average. So far the first half of Q4 indicates a sharp uplift in realized prices is on the way. Luckily for Shell, its upstream footprint is far more exposed to Brent which is fetching a nice premium to WTI currently.

Better liquids, namely oil, realizations should provide a very material uplift to Shell’s Upstream cash flow and net income generation this quarter. A trend that may carry into Q1 2018, we’ll have to see how the late-November OPEC+ meeting goes.

On a side note, Shell’s light sweet crude production in the Gulf of Mexico can fetch a premium to WTI by realizing Louisiana Light Sweet prices. LLS trades between $2-4/barrel higher than WTI (recently that has been at the upper end of that range).

However, investors should note that there will be a sharp increase in Shell’s Q4 capex versus Q1-Q3 levels. Shell’s capex is set to rise to at least $7 billion in Q4 after spending an average of $5 billion in the first three quarters ($15 billion plus $0.4 billion in investments in JVs) but that may end up even higher depending on where certain large items land. Management said capex shouldn’t exceed $25 billion this year, and that could be taken to mean Q4 capex could go up as high as $10 billion (which seems too large, most likely $8 billion is possible this quarter).

Efficiency gains, cost improvements, and solid operational execution (at least at the Shell-led projects) have helped Shell control its spending habits. Having a scrip dividend, which eventually needs to be dealt with in the long run, has made managing the medium term environment easier. Cash flow neutrality may be hard to achieve this quarter, but a strong upstream uplift means it is possible. Having major projects come online around the world will help out, especially as the Gorgon LNG venture (which Shell owns a quarter of) is now operational.

Farther out, Shell’s cash flow generation should be quite strong in a high $50s Brent world. The key is for its 2018 capex budget to remain closer to $20 billion than $25 billion.

Other considerations

After adjustments, all three of Shell’s divisions saw quarter-over-quarter improvements in income generation. Shell’s Downstream division (refineries and petrochemicals) accounted for ~60% of its operating income last quarter, versus 28% from its Integrated Gas division (liquefied natural gas and the related-midstream and upstream activities, and its gas-to-liquids fuels ventures), and 12% from its Upstream division (production of oil, natural gas liquids, and dry gas).

Keep in mind operating income and cash flow generation are two different beasts. As higher oil realizations start making Shell’s Upstream division the income generating giant it used to be, it will once again be a main contributor to its bottom line.

Something to keep in mind is that a higher Brent prices usually lead to better realizations for both contracted and spot LNG sales. Long term LNG deals usually are Brent-linked in some fashion or another. Spot liquefied natural gas prices have also firmed up quite a bit, with prices for Asian buyers trading at $8.50/Mcfas of October (significant improvement over Summer prices).

That will provide a major boon to Shell’s Integrated Gas division, especially as its Prelude floating LNG venture (off the coast of Australia) gets ready to begin operations within the next nine to twelve months.

Shell’s Downstream division is a juggernaut, with its 2017 results greatly exceeding its 2016 performance. A new petrochemical complex being built in Pennsylvania will help keep the momentum going over the long haul. The Pennsylvania Chemicals Project involves constructing a massive ethane cracker in the state capable of producing 3.3 billion pounds of ethylene a year alongside three polyethylene units with 3.5 billion pounds of production capacity per year. A lot of which will be exported to foreign markets.

Polyethylene is the most common type of plastic in the world. As American ethane production vastly outstrips steam cracking capacity (which is why a lot of ethane gets “rejected” back into dry gas streams), US ethane is significantly cheaper than in most other regions. By processing ethane into plastic, Shell hopes to generate strong margins through cheap feedstocks and strong global demand growth for plastic products. Two trends should be working in Shell’s favor, and construction has just begun.

In 2015 and 2016, Shell’s Q3 and Q4 Downstream performance was roughly flat indicating that historically speaking, this division should post a solid Q4. However, Shell’s refining margins broadly increased across the board in Q3 versus Q2 due to the impact of Hurricane Harvey. While Shell’s Deer Park refinery in Houston (with 340,000 bpd of capacity) was forced offline for some time, the margin boost realized at its other refineries appears to have offset those losses. Shell may see its Downstream income move a tad lower in Q4 as margins come back down.

Final thoughts

Royal Dutch Shell wants to push its gearing ratio down from 25.4% to 20%, a process that the firm has already been steadily working on as it has reduced its debt load by roughly $11 billion since the end of Q3 2016 (keeping in mind it issued out $0.8 billion in debt over that timeframe). Just over $10 billion in net debt reduction is a good start, with future proceeds and free cash flow generation enabling Royal Dutch Shell to keep the momentum going. Having a manageable cash flow situation is what made that possible.

Q3 was a solid quarter for Shell, and Q4 should be even better. If you want to read more about the firm, check out its FLNG Prelude development by clicking here.

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.


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