vervolg2:
In 2014, Shell promoted Ben van Beurden, head of refining, to chief executive. Van Beurden, 58, has more than 30 years at the company and is credited with turning Shell’s chemical operations from losses to profits. The hope is that he can make similar improvements for the broader company, improving its chronically low returns. In April 2015, with crude oil at about $60, Shell announced a $70 billion stock and cash deal for BG, a production company split out of the former British Gas—a 50% premium to the price before the deal was announced. Investors, viewing the deal as richly priced and uncertain, sent Shell shares 6% lower and BG just 27% higher. Charlie Price, who helps to oversee the $1 billion Aston/Pictet International fund (APCTX), bought BG and profited from the deal completion. He’s sticking with Royal Dutch Shell, now his largest holding. “BG is asset-rich, especially in natural gas,” he says. “Shell was asset-poor but has the infrastructure and expertise. Together, they’re the lowest-cost gas producer in the world.”
Shell had already begun shifting its production to a higher mix of natural gas as a bet on tighter environmental regulations, while investing heavily in facilities to liquefy and transport gas to bring it from low-cost markets like the U.S. to higher-cost ones. BG adds 20% to production and 25% to total energy reserves, including coveted deposits in the Santos Basin off the coast of Brazil. These are found beneath thick layers of salt but contain high-quality oil, and, for a deepwater specialist like Shell, they can be exploited at relatively low cost.
After the deal, valued at $53 billion at the closing, Shell is the largest gas producer and easily the largest liquefied-natural-gas, or LNG, company, and it ranks a close second to Exxon in total energy output, including oil. Close to 40% of its reserves could now be characterized as long life, according to UBS analyst Jon Rigby. That helps to reduce its need for constant reinvestment. Nearly three-quarters of Shell’s profit in a typical year comes from energy production. Much of the rest comes from refineries, a global chain of service stations, consumer products like Pennzoil motor oil, and petrochemical plants.
LAST YEAR’S FINANCIAL RESULTS give a sense of what Shell is up against. Operating cash flow fell below $30 billion, from $45 billion in 2014. If that seems like it’s still a lot, consider that Shell’s dividend alone costs $12 billion a year, and that in 2014 the company had more than $37 billion in capital expenditures. Last year, it slashed capex to less than $30 billion and paid $2.6 billion of its dividend obligation in shares under a voluntary program. It also sold $5.5 billion worth of assets. Return on capital employed shriveled to 1.9% from 7.1%.
Analysts can disagree over Shell’s true cost of capital, but there’s no question that the company is consistently earning well below it. That’s why investors cheered last month’s announcement of a growth plan that looks more like a shrink plan.
Shell says capital investment will total $25 billion to $30 billion from 2017 through 2020. That’s for the two companies combined, and it represents at least a 36% cut from 2014. Asked during an analyst presentation if $30 billion was a hard figure or if it might move higher if oil rebounds, van Beurden bristled. “What comfort can I give you, basically standing here and saying it’s not more than $30 billion?” he said. “What more do you want, yeah?” Shell, he said, has resources it can exploit well into the next decade. “You don’t have to go and look for stuff to spend capital on,” he explained, or perhaps confessed. “I’m absolutely committed that it will be $30 billion.” Van Beurden declined to talk to Barron’s.
THERE’S MORE TO SAVE. Shell says it expects the BG deal to yield $4.5 billion in yearly cost cuts and reduced exploration by 2018, up from an initial forecast of $3.5 billion. It’s targeting divestments totaling $30 billion through 2018, including $6 billion to $8 billion in the works this year. Van Beurden said the new budget is big enough to fund growth in select areas where he believes Shell has a competitive advantage. Priorities are deepwater drilling, particularly off Brazil and in the Gulf of Mexico, and chemicals; Shell last month announced it will build a vast new Pennsylvania plant to turn Eastern gas into the building blocks of plastics. These investments will be funded by other businesses that Shell calls its cash engines, including profitable wells, LNG operations, service stations, and oil-sands mining. Other businesses, such as shale and alternative energies, are categorized as future opportunities, suggesting that Shell will dabble there but not blow much cash.
A Shell platform off the coast of Sabah, Malaysia. Shell
The upshot for investors is that if van Beurden’s plan works, he predicts that by 2019 to 2021 Shell can generate average free cash flow of $20 billion to $25 billion a year—not counting divestments—after meeting its capex needs, while turning in a 10% average return on capital employed. That compares with organic free cash flow of just $5 billion a year on average over the past three years. The midpoint of van Beurden’s outlook, $22.5 billion a year, would give Shell a free cash yield of 10% based on its recent stock market value. It would provide more than enough money to quickly bring down debt and keep dividends coming, as well as share buybacks.
What could go wrong? Oil prices could remain weak for years. Shell’s plan assumes $60 oil by 2018, in line with the view of many analysts, based on production declines. The U.S. Department of Energy reckons U.S. oil production, 9.4 million barrels per day last year, will fall to 8.6 million this year and 8.2 million next year. China, too, recently cut its oil output sharply. If oil prices fail to rise, however, Shell could fall short of its free-cash-flow target, or have to settle for lower prices than it expects for its divestments. Management says the company’s back isn’t up against the wall on sales, and that the new cost structure is designed to generate enough free cash to cover the dividend even at the low point of the oil price cycle. But it could be wrong.
The stock’s valuation seems low enough to offset the risk. Over the past decade, Shell’s price/book value ratio has plunged to 1.2 from 2.5. On that basis, the stock’s discount to the Standard & Poor’s 500 index has widened to nearly 60% from less than 10%. Investors have been right to snub the stock based on rampant overinvestment at low returns. But that discount should narrow as the company reduces spending. A rise to $70 in a year would bring the stock to 1.4 times book. Exxon, which Evercore ISI’s Terreson estimates can earn an 11% return on its capital employed in a typical year, fetches 2.3 times book.
Better fundamentals for oil from here could continue to lift share prices for other energy names, too. The sector’s weighting in the S&P 500 has fallen to 7% from 13% since 2008. But Shell has more room for self-help than its peers. Now it also has the tools and, apparently, the willingness to change. Investors should buy for the yield, hold for a higher price, and sell at the first sign of straying from its new spending plan.