Like so many other integrated oil and gas companies, Royal Dutch Shell's (NYSE: RDS-A) (NYSE: RDS-B) goal of the past several years was to preserve capital by any means possible in the short term without giving up too much of the future. Based on the company's most recent earnings report, it has done a pretty good job of achieving that first goal. The second part? That is all up to what Shell's management does from here.
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There were several hints on the company's most recent conference call that suggest Shell has developed a new playbook that looks very different than its prior one. Here are quotes from that conference call that show Shell's possible future.
Making the grade
Shell has been trying to pull off an elaborate corporate shift over the past couple of years. It wanted to absorb and integrate BG Group into Shell, unload about $30 billion in assets from the combined company to lower total debt levels, reduce operating costs and capital spending, and get back to generating enough cash to cover capital expenditures and dividends. To make this transformation even more challenging, it was trying to do it in a low oil price environment.
Based on the company's most recent performance, it looks like management has pulled it off. Here's CEO Ben van Beurden taking stock of the situation.
Over this quarter now, we have a solid track record over a 12-month period with $38 billion of cash flow from operations, and that's at an average oil price of less than $50 a barrel.
So, we have more than covered the cash dividend for the fourth consecutive quarter. We have reduced net debt by almost $9 billion. We have reduced the gearing to 25.3%, that's from a 28.1% level a year ago. So, I think these are great measures of the progress that we are making, and that show that our strategy of delivering a world-class investment case is working. They also show that we are transforming Shell through the reshaping of the portfolio, as well as through structural changes in our culture and our ways of working.
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Production with a purpose
One thing that Wall Street obsesses over with oil and gas companies is the ability to grow production. It's so easy to poke holes in that metric, though. What good does it do a company to grow oil production today if it can't generate a return at current oil prices?
Shell has been taking a different approach lately -- or is at least communicating its production goals to the market differently. Typically, an executive will say how much new projects will add to the overall production portfolio. Van Beurden views its current development projects in a different light.
By 2018, we expect these projects [currently under construction] to be producing more than 1 million barrels of oil equivalent per day. That represents some $10 billion of cash flow from operations at a $60 oil price.
How much cash from operations a particular project or set of projects isn't how most other companies talk about their development projects. After watching so many companies go through cash crunches over the past couple years, however, it may be something to consider.
Hitting the mark
Royal Dutch Shell always had the reputation as the engineer's oil and gas company. It was the one willing to take on more technically challenging projects. That also meant that the company wasn't well known for generating superior returns compared to its peers. But when van Beurden took over, his primary focus with all of these corporate changes has been to improve returns on capital investment to the double-digit range.
When one analyst commented that its return on average capital employed (ROACE) had improved from 2% to 4.5% over the past year, he asked if it was possible the company could exceed its target range of 10%. In response, CFO Jessica Uhl did mention that some parts of the business are already there.
[F]irst of all, to point out, we have businesses in our portfolio that are consistently delivering ROACE of 15% to 20%, those are our Downstream and chemicals businesses. And overall, we're going to drive our businesses to have returns on capital employed to the full extent possible. And so, there is not a ceiling, I think we have a lot of ambition when it comes to what's possible with these assets.
Chemicals and downstream investments were a common thread in this conference call. If you were to read between the lines, you might think those statements were a suggestion of where the company could invest a larger portion of its capital budget in the coming years.
The growth engine may be outside production
Staying on that theme of downstream and petrochemicals, van Beurden did highlight that chemical manufacturing is one part of the Shell portfolio that could see some significant growth over the next decade.
[W]e want to grow these businesses as well and particularly the chemicals business. It's a growth priority, we want to double that business over the next, well, five, six, seven years now.
And then maybe we want to continue to keep on growing it, let's see where we get to first by the end of the decade or early next decade. So, we will be investing at elevated levels about $4 billion in chemicals. But if you were to remove all the growth that sits in there, this is a business that can sustain itself at levels that are much closer to $1 billion, $1.2 billion.
Is Shell underinvesting?
If you listen to oil service company conference calls, they almost all agree that producers like Shell aren't investing enough in developing new sources, and that could have a monumental impact on the price of oil and gas down the road.
When confronted with a similar question, van Beurden had a very different response.
No, I don't think we are. If you sort of fast-forward it a little bit, because we're only for you -- fast-forward it till the end of the decade, but believe me, we also fast-forward till the end of next decade to understand how this is playing out. We believe that $25 billion to $30 billion is the right level to significantly continue to grow the business.
If you wanted to, we can go lower, of course. I think we can -- if you wanted to keep the business where it is, and I'm not talking here about volume metrics, but talking about the financial performance of the business at reference conditions, I think we can keep the business at its current level, at levels that are probably around $20 billion or even lower than $20 billion a year. Of course, we can go even lower than that, but then we would be looking at a shrinking business. So, I think there is indeed a range of choices here, the choice that we have taken is that we want to continue to grow the business and at $25 billion we do that, and we do it in a way that is completely affordable and is also, I think, completely compatible with the capacity of the organization that we have at the moment.
There is a clear distinction between this response and the one we're getting from oil services companies lately. These companies are worried that we are underinvesting from a production perspective. Shell and other major producers think they are spending enough from a return perspective. Those are two entirely different things. Major capital investments in downstream and chemical assets don't do anything to help grow global production, but they can produce a long-term rate of return that will grow the bottom line. Also, as van Beurden pointed out, growing production should have the objective of generating cash flow and returns on invested capital.
What a Fool believes
If you take a step back from each individual comment here and view them all together, there is a common thread: Investing in production isn't as lucrative as it once was. So instead of focusing on those moonshot opportunities -- Arctic drilling, for example -- that would only likely be profitable many years from now, it is focusing on those investments that can make a decent return today. That means more downstream investments and being more choosy with its upstream portfolio.
I may be going out on a limb here, but it's also possible that Shell thinks the window for investment in oil projects is getting shorter. Van Beurden has already said in public interviews that oil demand will likely plateau around 2030 and that Shell is getting into selling electricity. These kinds of moves hint at the possibility that Shell is searching for life after oil, and it's trying to keep its options open. If the alternative energy market continues to progress at its current pace, that may be a good strategy.
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