Description

Description

I’m recommending buying shares in Royal Dutch Shell at £12.4/share to take advantage of the coming turn in the oil market cycle as supply rationalization exceeds any permanent demand destruction resulting from the COVID-19 crisis. 

With a medium-term (5 years) investment horizon in mind, I believe the absolute downside is limited and the base case potential returns (based on forward curve oil prices) are in the mid teens annualized. 

Thinking

• We are at the point of maximum pessimism for the industry. The sector weight in the MSCI World (4.9% as of 2019, compared to 5.7% in 1995) and S&P 500 (3.5% currently vs. 13.6% in 1990). At current prices and assuming they stay around current levels for the year, the world’s total oil bill would be about 1.5% of Global GDP, vs a 52 year average of 3.1%. 

• Pessimism is justified, but what’s being discounted is unlikely to materialize. The pandemic demand shock has been the once-in-a-century event nobody anticipated, throwing everyone’s plans in disarray and providing a catalyst for the industry’s capital cycle to finally turn: as profits collapse, managements change, incentives improve, capital expenditure is slashed, and the industry starts to consolidate. A recovery in profits should follow, supported by the ensuing supply/demand mismatch pushing commodity prices higher. 

• The impact of Covid-19 lockdowns on demand has been brutal: in China, it was down 30% in February. India, the third largest consumer, saw fuel consumption collapse 70% in April. The IEA expects 2020 global demand to be down 6% vs 2019. However, there’s room for hope. Already Chinese demand is back at 90% of its pre-Covid levels. Countries in Europe that have lifted restrictions are experiencing a surge in transportation demand, as is the US. Demand may be lower in 2020, but it will recover, and should still grow for a few more years. 

During the Global Financial Crisis, global oil demand fell by 2 million barrels and took less than 18 months to recover. 

• The supply response has been material: 

• OPEC+ have agreed to cut: 

• 9.7Mbdp in May and June 2020

• 7.7 Mbpd from July to December 2020

• 5.8 Mbpd from January 2021 to April 2022

• Norway agreed to cut production by 250,000 barrels per day in June and by 134,000 barrels per day in the second half of 2020. Additionally, the start-up of several fields has been postponed until 2021. 

• Canada is expected to produce 600,000 less in 2020 vs. 2019. 

• In the US, as of late April, a group of the largest 25 E&Ps had lowered production expectations for 2020 by 563,000 barrels. For the week ending May 8th, the US rig count hit its lowest count level since 1975, and as of May 15th, it stood at 258 oil rigs, 68% below 2019 year end levels. As a result, US production (total crude and NGLs) should be around 3-3.5 million barrels lower than 2019s. 

• In addition to the agreed cuts of late April, Saudi Arabia announced in mid-May it had cut production by an extra 1 million barrels per day. 

• The supply response could be more permanent than anticipated.

• Global Oil Majors have announced capex reductions of 20-25% vs. original 2020 budgets. Lower capex leads to lower production in future years (for instance, Exxon’s capex cuts in the Permian basin this year are expected to affect production by 150kbpd in 2021). US independent E&Ps have announced capex reductions of ca. 35%. In aggregate, total industry capex could be down anywhere between $60-100bn in 2020. 

• Bernstein expects ca. 1 million barrels being permanently shut-in. Smaller fields (<10kbpd), oil sands, Deepwater late-life fields. These would be unlikely to come back as the investments required would be uneconomical. 

• Appetite for new investments is low: current prices and outlook too negative. Private Equity has had a poor experience so far in US Shale, Canadian Shale, Gulf of Mexico, UK North Sea. Management teams would be reluctant to commit capital to long lead-time projects, with the future of demand being questioned on a daily basis, pressure from climate change debate returning to the forefront after COVID crisis, and 

• An increased focus from boards on these risks but also on the sustainability of businesses and returns on the capital employed. Looking at Shell’s remuneration policy, for instance, 30% of annual bonus is conditional on operating cash flow delivery, and 67.5% of LTIP outcome depend on relative ROACE and Cash from operating activities, and absolute free cash generation. About a third of BPs LTIP is based on ROACE metrics and 30% on relative TSR.  Exxon incorporates ROACE metrics into the LTIPs already and so does Chevron, TOTAL, Equinor. These have become more relevant and have gradually been replacing TSR or EPS metrics. 

Source: Shell 2019 20F 

Source: BP 2019 20F

• Against this background, oil majors are discounting $30-40/bbl oil prices going forward. For the reasons mentioned above I believe this is too pessimistic and ultimate prices are likely to be higher. They can’t remain below $30/bbl for too long because that is roughly the marginal cash cost of Global non-OPEC, ex Russia producers (which includes the majors) and ca. 5-6 million barrels of production would need to be shut down. See below:

Source: Bernstein

• The good thing is they don’t need to be much higher for investors to realize low to mid teen annualized returns in the coming 5 years across the sector. 

In a nut-Shell

To a greater or lesser degree, most Oil Majors operate somewhat similar business models. Shell and Exxon’s are the largest of the group and have the most comprehensive array of businesses. In Shell’s case, they touch every aspect of today’s energy supply chain. See below chart for reference: 

Source: Shell 2019 20F

After the latest strategic plan, Shell looks at their activities in three core groups: Integrated Gas, Upstream and Downstream, with a fourth, Projects & Technology, managing the delivery of major projects and driving R&D across the other three. 

Integrated Gas comprises natural gas exploration, extraction, LNG activities, natural gas conversion into GTLs; Gas upstream and midstream infrastructure; LNG, natural gas, electricity and carbon emissions trading. The New Energies business is also included here. Shell’s total LNG sales volumes have increased from 39.5 Mt/year in 2014 to 74.5 Mt/year in 2019, with 39 Mt/year being trading volumes and the rest equity LNG. Total LNG liquefaction capacity today stands at 42.3 Mt/year. 

Upstream comprises exploration and production of conventional oil and gas, deep water and shales, as well as midstream infrastructure operation to transport and market production. Shell’s upstream production was 2.7 million bpd in 2019, with 63% of these liquids and the difference gas. 

Downstream comprises oil products and chemicals refining, as well as the retail operations. As of 2019, Shell had ca. 46k branded retail sites, generating about $55k/year of earnings each. Their refining system can process 2.9 million barrels of oil per day in 21 refineries around the world and utilization has been 89% on average over the last 5 years. They also sell ca. 15 Mt of chemical products every year. Refining operations are expected to continue declining while chemicals should grow as this has been an area of focus for the business in recent years. 

Source: Shell 2019 20F

Why choose Shell amongst all the majors? 

A good question. It’s not a good business. Its cumulative long-term returns are poor: 3.15% annualized returns since 1988, including dividends. To provide some frame for comparison, Exxon, while underperforming the S&P over the same timeframe has delivered 7.9% annualized returns. 

Source: Bloomberg

At least it has outperformed the commodity over a 32 year period: oil appreciated at 2.3% annualized, vs. 4.3% for Shell and 8% for Exxon. 

Source: Bloomberg

At least, in the last decade, it has done a little better than Exxon. However, investors would have done much better owning pretty much anything else but either. 

Source: Bloomberg

Lastly, since May 2008, Shell has delivered 2.5% annualized losses, similar to Exxon and worse than major benchmarks. 

Shell has a reputation for poor capital allocation. Deserved, in my view, simply by taking a look at their acquisition of BG in 2016 and the way the deal was structured. By the stubborn commitment to paying $15bn in dividends each year to shareholders since (“the dividend was sacrosanct!”) and their commitment to repurchase $35bn worth of shares, to offset the BG deal dilution and “reward” shareholders, regardless of price (much less intrinsic value). 

From 2010 until 2019, Shell generated $377bn of operating cash flows (including 51bn of asset impairments), invested $300bn organically and inorganically, thus generating $78bn of FCF. However, they paid a total of $105bn in cash dividends and repurchased $30bn worth of shares, creating a $45bn hole which was plugged with $10bn of net long term debt and $78bn of asset divestments.

All this delivered 1.6% hydrocarbon production CAGR. Meanwhile, refining throughputs declined at 2% per annum (as a result of divestments).

If you have not been following the oil and gas sector in a while, you would think this must be an exception. Sadly, pretty much all majors have been following a similar playbook (excluding Exxon and Rosneft, BP, Total, Equinor, Chevron, ENI, Repsol, Petrobras, and the larger E&Ps have all been borrowing and selling assets to pay an increasingly burdensome dividend)

So, why Shell? Or why any of them at all? You can very happily walk through life without ever investing in commodity businesses. You can save yourself much worry and trouble. But if you feel compelled to give it a try, I believe now is a good time to buy exposure to the sector. Shell’s recent change of heart regarding its dividend policy gives me hope that it can provide sufficient leverage to an oil price recovery for investors. 

• Shell is exposed to four distinct capital cycles: upstream oil & gas, LNG, oil refining and petrochemicals. As mentioned above, I believe the oil upstream cycle is turning fast, LNG will do so over the next couple of years, refining is a business Shell has tried to reduce exposure to for over a decade and petrochemicals should see a rebound post Covid, although it’s likely the sector will remain oversupplied for a few years. 

• Compare Shell’s earnings calls from 2016 with the 1Q20 call. The debate around their financial framework is always entertaining, but specific comments about the dividend are interesting: “When considering the impact of the current macroeconomic climate on our organisation, and the risks of a prolonged period of economic uncertainty, weaker commodity prices, higher volatility, and weaker demand in all our businesses, the Board does not consider that maintaining the current level of distributions is in the best interest of the company and its shareholders” and “We believe the reset level of dividend provides a platform from which the company can reinforce the balance sheet over time, continue to invest in our business, and also pay a meaningful and affordable dividend with the prospects of growth and additional returns when macroeconomic circumstances allow. Although the absolute level of our dividend per share will now be lower, our cash priorities are unchanged. As we move forward, the Board will continue to evaluate very closely the way we prioritise between retaining a strong balance sheet, investment in our businesses and increased cash distributions to our shareholders”. The fact that it’s the same CEO (but a different CFO) who both defended the dividend back then and has now implemented a >66% cut is remarkable.

• If capitalized, the $10bn dividend cut they just made would equate to around $150-180bn in extra liabilities, given the previous approach by management. By removing this, Shell has become one of the only majors capable of enduring a longer period of low oil prices without having to further increase its borrowings. They have also reduced their dependence on divestments, a good thing in what must be a tough environment to sell oil & gas assets. 

• Having been around for over 100 years, Shell knows how to survive. The dividend cut to me is a “whatever-it-takes” moment. They should now be able to manage through the energy transition ahead. My thesis is in no way an endorsement of Shell’s financial framework or the underlying attractiveness or their leading market share in LNG production and trading, for example, but more a recognition that the value of the company will inevitably rise with higher commodity prices. In the past, following oil price shocks, the shares have delivered attractive double digit returns: 

Source: Bloomberg

• Since 2014, Shell has reduced production costs by almost half and total unit costs by 25%. Peers have done the same. They will likely continue doing the same, as they move to pure maintenance capex and continue pushing through digitalization improvements. They’ve announced $3-4bn annualized operating cost reductions to be delivered in the coming 12 months. Ultimately, these will make them more robust to commodity price shocks. 

• Higher oil and, hopefully, gas prices in the next five years should provide the support and upside to investors.

Valuation: 

There are a couple of (simple) ways to look at this. Let’s start with Shell’s shared estimates: 

1. In the days pre-Covid, slide 14 of their 4Q19 results presentation showed how the company was able to generate between $25-30bn of Free Cash at $65/bbl oil prices. They guided for $24-29bn of CAPEX, so I assume implied operating Cash of around $49-59bn.

Source: Shell FY19 results presentation

Shell’s Operating Cash flow sensitivity of $6bn for every $10/bbl move in the oil price, based on disclosure on their  Nov 2017 Investor Day. 

Assuming oil averages $35/bbl in 2020 (YTD avg is $41/bbl). The operating cash move could be around $18bn. With new capex guidance of $20bn as of the 1Q20, FCF for the year could be around $15bn. 

With no production growth (as the business moves to maintenance capex mode, so you end up with the same 3.6MMbpd of hydrocarbon produced in 2019) Assuming $35/bbl in the next 5 years, shell could generate roughly $15bn of FCF/year before any further cost reductions, capex cuts, petchems cycle turn, etc (they’ve already announced >$3bn of additional opex cuts for example). $5bn will be paid out as dividends and the retained cash could be used to repay debt, which as of the end of the 1Q20 stands at $74bn. Assuming similar debt repayments over 5 years gets you to $24bn of net debt at the end of 2024. A 10x multiple minus the net debt gives you a terminal value of the equity of$126bn. You’re paying £99bn for the equity today. At a 10% discount rate you’d be getting about £5/share of NPV, or 40% of the current price (converted to £ at 1.22)

That would be a worst case in my view, given the dynamics in the oil market discussed above. 

At $40/bbl, it works out to about £9.1/share of NPV, ca. 70% above current price. 

You’d also be getting a dividend yield of about 4.2%, covered for the first time in a while. 

2. Shell has $274bn of Net operating assets today. The market cap has been 1x its net operating assets on average over the last decade. The average for 2016 was 0.7x. It’s trading at 0.4x today. A reversion to 0.7x, gives you about 58% upside to the current share price.

Finally, Shell’s PV10 from its latest 20F shows about $72bn of NPV from future cash flows, compared to a market cap of around $121bn. This value is derived from the upstream and integrated gas current proved reserves, but does not take into account Shell’s refining, trading or chemicals operations, which represent over 2/3rds of the total capital employed and roughly a similar percentage of earnings. 2020s PV10s will show some decline as a result of lower prices, but the support provided by the oil & gas reserves is still valid and very true, limiting your downside. 

Risks: 

• Management / Capital allocation / Energy transition challenges - climate change – net zero: 

On their own, each of these is a significant risk to any investment thesis, but for (fossil fuel) energy companies these are all very real. The business is cyclical. Management teams may understand cyclicality but very few can manage the business through cycles to make it stronger (I’m not implying I could do better) and Shell’s history of capital allocation is poor. Going forward, the typical challenges of managing energy commodity businesses will be compounded by the requirement (from regulators, governments, society) that these businesses contribute towards reducing emissions. 

Shell has recently announced their commitment to become a net-zero emissions energy company by 2050 or earlier. One of BP’s new CEO first announcements in February of this year was his commitment to become a net-zero emissions company by 2050. 

From a shareholder perspective, goals like this tend to be of little attractiveness. To me they sound like BHAGs (Big Hairy Audacious Goal, https://www.jimcollins.com/concepts/bhag.html) but the environment required for them to be delivered is hard to create in oil majors: management have little skin in the game (and most of what they have they haven’t really paid much for if at all) and will be allocating $25-30bn annually of shareholders’ money (op. cash, Capex budgets); who knows where today’s management will be in ten years. in 2031, they will still have 19 years to deliver (or not) on today’s net-zero commitment, will the next management in place continue with the pursuit?; I’d argue a BHAG like that requires a VERY strong corporate culture to be achieved, how do you even think about building a strong corporate culture at BP after laying off 15% of your workforce in the last 3 years, and who knows how much more in the coming three?; if everyone is determined in delivering net-zero goals and the opportunity set for doing so is finite, what sort of returns can be expected? 

Will governments around the world finally agree to impose synchronized taxes on carbon? Will the traditional providers of capital to the industry leave to never return? These are difficult and relevant questions, but it’s also true that the risks they pose are as much to the upside as to the downside. 

• Time / industry structure: 

As much as I believe that the oil and gas capital cycle is on the turn, there’s no denying how fragmented the industry remains – which creates significant challenges for consolidation – and how divergent the different players’ interests are – which exacerbates and extends irrational behaviour. The severity and proximity of the recent price shocks (2014, 2016, 2020) in my view accelerates the cycle turn, but there’s no way to tell whether we will finally emerge from this in the next 6 months, or 24. Still, economics must prevail, and $30/bbl seems to be the price below which enough production around the globe is uneconomical. So even if irrationality persists for still some time, I still think the money you’ll make will be worthwhile your wait. 

• Demand not recovering? 

At the end of 2019 the world was consuming roughly 100 million barrels of oil per day: 

Close to 55% of the total is related to transportation, which is disproportionally affected by the recent COVID-19 lockdowns. As seen in places where restrictions have been lifted, demand does come back. Aviation demand may take longer, and freight, maritime and petrochemicals demand may be more affected by the ensuing economic contraction still in progress, but judging from 2008-09’s experience, it won’t go to zero, much less disappear. 

• Valuation: will oil majors go down the route of coal miners? 

With valuations for these group in the low single digits multiples of FCF today, is it reasonable to use 10x FCF as a terminal multiple? If the right multiple is lower, required oil prices to make the case work are significantly higher. They are feasible – especially if the sector is definitely starved of capital and the world heads into a severe supply shock in a few years – but don’t represent a reasonable base case. 

• LNG / Gas: 

Half of Shell’s production is gas/LNG and about a third of the total capital employed is in the Integrated Gas division. Shell is the largest LNG producer in the world with volumes of 36 Mt/year and the largest trader LNG with 39 Mt/year. LNG follows a different cycle, although the majority of contracts today globally have a linkage to oil prices. The industry has been in oversupply for the last couple of years, but demand has been growing steadily. 

The current spot LNG and gas pricing in all basins is well below marginal cash costs of $4/mmbtu and long-term marginal cost of $7-8/mmbtu, making the rational for further LNG capacity investments more difficult. Covid-19’s impact on power demand has decimated gas prices, as reflected by contract LNG, UK NBP and Asia spot LNG at historical minimums. 

There’s still a case for increased coal-to-gas switching in Asia, and even in Europe, so there’s hope for a turn in the cycle as demand matches and eventually surpasses supply in coming years. 

Source: Redburn

In the short and medium term, Shell’s ca. 90% of oil-linked contracts protect the downside in Integrated Gas, but in the longer-term, the question about how LNG moves to a fully spot based market lingers. So far, in recent years, contracts have been signed or extended with a link to oil prices, so the acceleration to a 100% commoditized market has not materialized. 

Shell’s trading operations also offer a cushion on the downside. Bernstein estimates the trading operation generates about $1bn of earnings per quarter, in good times and bad. That will be tested in 2020 for sure. 

Catalyst

Sustained oil supply reductions, US Shale related bankruptcies, capex cuts, etc. 

Higher oil prices, higher gas prices, sustained recovery in oil & gas demand

Other majors changing dividend policy (rebasing dividend payments): at current prices, it means capital being sucked out of the sector which is a positive