As is common knowledge, the price of crude oil has plummeted this year and shares of the international oil companies have plummeted along with it. This can be an opportunity, as Royal Dutch Shell (RDS.A) (RDS.B) is trading near the lowest point since the current share started trading 15 years ago. Adding insult to injury, the stock has lagged the market severely since 2015 and even more so this year.
Source: Seeking Alpha/TradingView.
However big the normalization opportunity may seem, there are several problems with Shell’s investment thesis that have been brewing for longer. In this article, I have four charts that show the company’s deeper issues. Firstly, profitability has been sub-par for years, while the P/E multiple increased in anticipation of a recovery of the oil price. So, in that respect, 2020 did at a greater speed to the stock’s valuation what probably should have been done earlier on. In addition, I am concerned about the investment level of the company and the long-term outlook for oil & gas reserves.
Discussing Shell is always tough as it is a very large company and it’s very easy to get lost in details, which is why I focus on the major parts of the business case for the purposes of this article. What investors should know is that Shell is big in gas and oil, both upstream and downstream. Its downstream operations, refineries, and gas stations are not as profitable as oil and gas extraction but provide a cushion when times are tough. Nowadays would be such a time with WTI crude just below $40. However, due to a severe global crash in demand, refining margins are down the drain and this cocktail of low oil & gas prices, as well as imploded global demand, led Shell to its first dividend cut in 80 years.
Obviously, a higher demand for oil and a higher oil price will help, but predicting the oil price is nearly impossible. One insight is that crude is trading contango, so the market expects the price to go up but not that fast. This also touches on the main problem with the investment thesis; Shell’s shareholders for a long time hoped for better times, not realizing that maybe $60/barrel is a good price for crude. To name an example, BP (NYSE:BP) this year revised its 30-year forecast for the oil price from $75 to $55.
But let’s not get ahead of ourselves. How has Shell actually performed on earnings and valuation over the past years?
Chart 1&2: Earnings have lagged the stock
As mentioned earlier, Shell has been hurting from a lower oil price. Shown in the chart below is how Shell’s EPS over the past five years has been structurally below the levels of 2010 to 2014.
USD annual earnings per Amsterdam-listed RDSA share. Source: shell annual reports/2020e EPS is analyst consensus. Averages are 2010-2014 and 2015-2019.
An important uncomfortable fact is that shareholders mostly adjusted to this reality be upping the P/E. While Shell traded at a P/E of roughly 8 to 12 up to 2014, this has moved up materially since. It seems that investors have been too optimistic about Shell’s prospects.
Year-end RDSA share price (in USD) divided by annual EPS. *2020 estimate uses Thursday’s price in Amsterdam converted to USD ($12.16) and 2020 consensus Adjusted EPS. Source: author’s own calculations, company-compiled consensus, company share price data.
Of course, this is not the full story, as the company maintained its dividend up to this year, which is something that investors care about. The company worked hard to keep that dividend record of uninterrupted increases intact.
An explanation of the resilient share price of the past couple of years can be that the company invested a lot over 2010 to 2015 and that the much reduced investment level of 2016 and beyond freed up so much cash flow that it enabled Shell to continue to reward shareholders handsomely.
Operating cash flow per share (outstanding at year-end) split in net capex and FCF. Source: author’s own calculations.
The flip side of this is that a lower investment level will have long-term consequences. Also, it is a reflection of poor capital management. While it is understandable that the company reduces investments when times are tough, a countercyclical investment strategy is best in the commodities sector. Investing is best done when others don’t as the rising crude tide lifts the price of suppliers, employee wages, and concessions.
An example from Shell is the figure below that shows the break-even price per barrel for deep sea projects in 2014 and 2017. Clearly, 2017 projects have a much better break-even price which was in a large part because of supply/demand dynamics, rather than just Shell being disciplined or smart. Drilling rigs/ships just got a lot cheaper to lease for example.
Source: Shell 2017 investor presentation. FID is Final Investment Decision.
Deep sea drilling looks like an isolated sub-segment within oil, but the same principles stretch out to all types of oil extraction. For example, the Permian basin area, an oil hot spot, saw truck driver salaries of $140,000 in 2018. Oil price uplifts and downturns trickle down throughout the chain. Schlumberger (SLB) and Halliburton (HAL) saw their margins slide in 2015 and 2016 as oil companies cut capital expenditures. Maybe it’s too easy to blame Shell for investing at the peak, as all companies did the same, but it shows that the cash flow upside remains limited when prices rise and that there will be work to catch up on.
It is not just the cost of investments to worry about. It is perhaps more important to consider the long-term business of the oil company, which is captured by its reserves. Ideally, an oil company is able to replace every barrel produced from its fields with new discoveries. As can be observed from the table below, Shell has failed to do this over the past years.
Source: Shell 2019 Investors handbook.
In its last Q1 earnings call, the analyst from Citi asked the following question that hits the core of the business:
And the observation is the SEC reserve life, of course, keeps on falling. We’ve seen the disclosure from 2019 now. It’s 30% below where you bought BG [British Gas, acquired in 2016]. You remain well below your key peers. So how do we have confidence that the spending level that you have been running at or indeed the revised $20 billion spending is enough to grow organic free cash flow?”
The answer to this question was long, but came down to: ‘you should not focus on reserves and we think that that $20bn supports the current level of cash flow going forward’. In my opinion that means that the company does not expect to replace its reserves in the near future.
Planning is subjective, but when we stick to the facts, we see that the company has done a poor job of replacing reserves in the past, despite its elevated CapEx levels prior to 2015. While spending an average of $27bn (gross CapEx, excluding M&A) per year, the company only managed to add more barrels than it extracted in just 4 out of the past 10 years.
Barrels of oil equivalent production and replacement (excluding acquisitions and divestments) as a percentage of proven reserves. Source: author’s own calculations, Shell Investors Handbook 2019, 2015.
The trouble is that it will get increasingly tough to replace barrels with a CapEx level that is so much lower than the past average. All of this leads me to believe that the company attached some optimistic assumptions to its assertion that (oil price aside) $20bn CapEx will sustain its cash flow. The chart above also shows that the company extracts 12.5% of its reserves every year, so, in theory, it has only 8 years left if no reserves are added. An important aspect of reserves is that barrels have to be recovered profitably and it uses the year-average oil price. This means that the current reserve level is based on last year’s oil price and could be adjusted downward.
Aside from reserves and earnings, cash flow from operations is hugely important. In this environment, Shell’s oil business struggles to become cash flow positive. The gas business has been doing a little bit better YTD but faces a grim outlook as its LNG contracted prices are linked to crude with a lag of 3-6 months, so Q3 will see more damage.
So, what is in the value of Shell? If we take the free cash flow of 2019, the FCF yield is a mouth-watering 25%. Adding debt to the denominator pushes the down to 15%. In my opinion, the shares can double if oil fully recovers back to last year’s levels, but that is not a very likely scenario.
A rule of thumb is that a $10 lower oil price decreases earnings by $6bn. We are now $15-$20 below the level of crude observed in 2019. This implies a forward earnings level of $4bn to $7bn. In the short-term, we should look at the lower side of that range as downstream is impacted more than a $10 lower oil price usually involves. However, if we assume a bit more normalization and take $10bn (adjusted earnings consensus for 2021 is $11bn), then the P/E is roughly 9.5. I think that this is pretty fair for a non-growing company in an industry that has probably reached its peak, or at least, is close to it. The high net debt level is still left out of this equation, so perhaps a bit more normalization is welcome in order to make Shell worth its current price.
Shell may seem cheap now, but it has been relatively expensive over the past five years in my view. A large part of the correction that we have seen this year is simply a healthy re-rating of an expensive stock. Investors may still be tempted by the 60% discount versus the price at the end of last year, but a return to what used to be normal ago is a risky bet when it comes to oil. Aside from that, Shell has been underinvesting in its growth over the past five years and this will certainly come back to bite it.
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.