Summary

• Royal Dutch Shell Plc (Shell) is the largest integrated energy company in Europe. The company is going to reshape its product mix with the ambition to become a net-zero energy emissions business by 2050.
• It entered pandemic related crisis more indebted than its peers. The burden led to the painful dividend cut this year.
• Third quarter earnings release provided encouraging signs: it returned to profit after two quarters of losses.
• We discuss the implications of the recent developments on volumes of production, profitability and dividend income of the company.
• The attempt is made to evaluate how those metrics could unfold in the future and what kind of returns on investments could investors expect.

Dividend    Revenue    Profitability    Financial Strength    Investment Case

Please note that in our website we divide Shell’s ADR price by 2 for consistency of the calculation of performance ratios as 1 ADR represents 2 B shares of the company.

Shell (RDS.B) is the largest energy group in Europe with its energy and petrochemical companies acting in over 80 markets and serving over 30 M customers every day. It is integrated company involved in all the main areas of energy business:

• Upstream – explores for, extracts and delivers oil and gas to the market. The most profitable division of the company.
• Integrated Gas and New Energies – converts gas to liquids; invests in low-carbon energy.
• Downstream – manufactures and distributes oil products and chemicals.
• Projects and Technologies – manages Shell’s major projects, drives research and innovation.

Shell belongs to the industry troubled with many headwinds – both short- and long-term – pandemic related economic shock, climate warming issues, high indebtedness. Shell’s share underperformed its peers. It is down 42% this year. The price is recovering since March low of USD 9,6.

Green Ambitions of Shell

Currently the company reshapes the product mix by growing its low-carbon businesses. It has the ambition to become a net-zero energy emissions business by 2050. That means moving away from oil towards Liquefied Natural Gas (LNG) and renewables. So Shell is positioning itself for long term success as the renewables are constantly increasing in importance. This transition means a lot of restructuring activity and higher spending on greener projects in the coming years. However the transition can take many years as the starting point is low: investments in the green projects do not exceed 5% of total capital expenditure of the company.

Oil: Always at Supply-Demand Crossroad

There is quite high uncertainty about the future performance of the company as it is very sensitive to the oil prices. At present, due to pandemic related plunge in demand and other factors, oil prices fluctuate around USD 40 per barrel. When economies around the world recover, they would need oil since renewables are not capable to replace it in the near future. Then oil prices should recover along with the recovering demand. Shell projects long-term oil price of USD 60 per barrel. In the short term prices probably will be lower than that. U.S. Energy Information Administration predicts Brent crude oil on average at USD 46.6 per barrel in 2021.

   Dividend

In 2019 Shell generously rewarded shareholders by paying about USD 15 B in dividends and buying back shares worth USD 10 B. However worsening macro conditions put huge pressure on the company. In the spring Shell disappointed shareholders by cutting its dividend by two-thirds, for the first time since World War II. That was a consequence of a crash of the oil price and lower demand for company’s products. The cut gave company flexibility to deal with its debt. The dividend yield is 3.8% at present. In Q3 2020 results announcement company confirmed that it resumes dividend growth and increases a dividend by 4% to 16,65 US cents for the third quarter. So 2020 is the special year for Shell as it slashed a dividend substantially and then increased it slightly in the same year. The company announced that initially CFFO will be used to reduce the company’s net debt. After that a total of 20-30% of CFFO will be distributed to shareholders each year via dividends and share buybacks.

   Revenue

Unlike companies in other industries, energy companies have little control over their revenue as it depends on commodity prices. Due to low oil prices and lower demand Shell reported 9 months 2020 revenue of USD 136.6 B, 48% less than in the same period last year. Revenue also depends on the volumes of production since one can sell only what is produced. Here a company has more of control. The level of production is one of the key indicators of the future success for an energy company. For future productions a company needs reserves. Shell produces 1338 M boe per year and its reserves stand at 11096 M boe. So the company has reserves for about 8 years. In turbulent 2020 Shell’s oil production is in decline. In Q3 earnings release production figures reveal that production was 14% lower than in Q3 2019 and in Q4 it is expected to be even lower. When a demand for Shell’s products recovers, the company’s enhanced position in natural gas and existing portfolio of projects should allow returning to some production growth. The company’s Capex is expected to be in the range of USD 19B – 22B, lower than in the past but good enough to grow its business.

   Profitability

Company returned to profits in Q3 (adjusted earnings of USD 1B). These come alongside with some recovery in oil prices and improvements in demand. However for energy companies Cash Flow From Operations (CFFO) and Free Cash Flow (FCF) are better indicators of a company performance than earnings as earnings are substantially affected by write downs, impairments and depreciations. Historically Shell has had strong but volatile CFFO.

Shell’s third quarter CFFO (excluding working capital) is USD 9 Bln and FCF USD 7,6 Bln. That is particularly good if you take into account current low commodity prices. Shell takes many steps to improve profitability. The company focuses oil production in the low cost areas. In order to reduce costs the company intends to cut up to 10% of its workforce. The company’s EPS for 9 months of this year is negative at USD -2,27 per share. However it managed to get back to profits in third quarter, unlike many of its peers. The following picture shows just how much CFFO per barrel is correlated with oil price in the company’s Upstream business.

We can safely assume that the production growth can be weaker in the near future than in the past. However the cost discipline and improved production efficiency should help the company to return to the past profitability with the rebound in oil prices.

  Financial Strength

The debt increase, related to BG Group takeover, made Shell more indebted than its peers. At the same time Shell has a very high AA- rating for its long term debt from S&P rating agency. Shell intends to reduce net debt from USD 73,5B to USD 65B in the near term in order to preserve its rating. Fortunately the interest rates are low and stay so for a while, so the interest burden on company is not high.

  Investment Case

In our simplified model we make the following assumptions:

– Oil is USD 60 per barrel in 2025 and CFFO is gradually back to pre-covid level, i.e., of the same magnitude as in 2019. In 2019 CFFO was USD 42 B;

– The future dividends are on average 25% of CFFO;

– The company implements the policy of gradual yearly dividend increases;

– We ignore buybacks and the debt reduction issue.

With those assumptions the amount to be paid in 2025 in dividends and buybacks could be around USD 10.5 B. It is much less than USD 25 B paid out in 2019. So the reward would not reach a generous pre-crisis level.

If the number of shares of the company (7.807 B) is not changed, a dividend per share would be USD 1.34 per year (10.5B/7.807B). So, in our model the dividend doubles in 5 years period: from USD 0.67 in 2021 (USD 0.1665 in third quarter multiplied by 4) to USD 1.34 in 2025. So the total dividend income over the next 5 years could be USD 4.88 per share, as shown in the table below.

Year	2021	2022	2023	2024	2025	Total
Dividend per share, USD	0.67	0.8	0.95	1.12	1.34	4.88

Now we make an estimate of future stock price by using P/E metric to get a broad idea about possible stock price movements in the future. For our calculations we assume that, with oil price of USD 60 per barrel, EPS for 2025 is close to what it was in 2019, i.e. USD 2 per share.

Multiplying it by the average P/E over the last 5 years (21), gives us the rough indication what could be the stock price in 5 years period:

USD 2×21=USD 42

That means Shell’s stock price upside potential of 140% from the current price USD 17.56.

Taking into account the expected dividend income over the next 5 years (USD 4.88), the overall return on investment, if the stock is bought today, with dividends not reinvested, could be around 167% over 5 year period or about 22% compound return each year on average.

Risk Versus Reward

Such level of return on investments always comes with the high degree of uncertainty. For Shell these are:

• The company is heavily dependent on the oil price and that price is highly uncertain.
• The company bets on natural gas, hydrogen and renewables. They can play out nicely. However it could take many years to happen. Also there is a risk that without subsidies renewables could be unprofitable for years. So, it is difficult to measure how much shareholder value can be expected from the move. In the next few years this move will not have material effect on performance as investments in this field are low.

The management’s flexible approach, demonstrated so far, should insure that the right mix of businesses is in place at each point of time. If oil price reaches USD 60, as expected by Shell, the company could start rewarding shareholders once again through growing dividends, share buybacks and the share price appreciation.

HSBC upgraded Shell from Hold to Buy on November 09. It said “In our view this is warranted by Shell’s robust cash flow and improved clarity on its capital framework”.

Disclaimer

I am long RSD.B.

Notes

Source of pictures – the company website (unless otherwise stated). The estimates made in the article are for the informational purposes only. They are the result of the rule of thumb assumptions and the real outcome might differ materially from those estimates. As the future unfolds, macro events, not mentioned in the article, could impact the company fundamentals. Use the information in the article as a starting point for your own due diligence.