There is something interesting going on between two major oil and gas companies. Both Royal Dutch Shell (RDS.A, RDS.B) and Chevron Corporation (CVX) announced their long-term strategy last month. The difference between the two strategies could not be greater. Shell recently appointed Mr. Ben van Beurden as its new CEO. Mr Van Beurden announced a completely new strategy on January 30, 2014. On the other hand, Chevron announced that the company holds on to its previous strategy on January 31, 2014. This article provides an insight in both strategies and argues which of the two strategies is most likely to succeed.
The future strategy is a major issue among oil and gas companies. In recent years, almost every major oil and gas company decided to spend a very large sum of money to fight off the revenue declines. For example, Chevron spends $41.9 billion on energy projects last year, a 23% increase compared to 2012. Shell spends a net $40.1 billion in capital expenditures last year, a 23% increase compared to 2012 as well. Despite the heavy spending, both companies reported worse than expected results over the fourth quarter. According to Shell's earnings report, revenue decreased to $109.24 billion from $116.51 billion and net profit fell 71% to $2.2 billion in the fourth quarter. Chevron reported that its fourth quarter revenue decreased to $56.16 billion from $60.55 billion and net profit fell 32%.
Overall, the market conditions within the oil and gas industry are though. The companies experience lower production from existing fields and higher than expected expenditures for the development of new fields. As a result, revenue and the production of oil and gas decrease. Meanwhile, the industry tries to control the level of capital expenditure by introducing innovative solutions. For example, Shell is building the world's largest vessel to produce liquefied natural gas in Australian waters. According to Shell, the production costs of the facility are 30% cheaper compared to the traditional production costs of such a facility. The adoption of the more efficient techniques takes time. In the meantime, the operations of the oil and gas companies will continue to face strong headwinds.
Royal Dutch Shell's strategy
As I mentioned before, Shell's net capital expenditure was $40.1 billion last year. Shell assumed that it could make up for the lower production by spending a lot of money on the development of new fields. However, the company experienced that this strategy comes with a cost. Shell's main focus was to increase production and stop revenue from falling even further. The company did not focus enough on the profitability of the new fields. In December 2013, Shell acknowledged that the development costs of several projects are just too expensive to continue. As a result, the company took precautionary measures to achieve its mid-term objectives. For example, Shell decided to back out the Louisiana Gas-To-Liquid project.
Soon after Shell appointed Mr. Van Beurden as the new CEO, the company announced a new strategy going forward. Shell stated that a new strategy is necessary because the current market conditions are different from the company's expectations. For example, the refining margins are under pressure and North American gas price remains low. Therefore, Shell will cut capital expenditure to $37 billion in 2014, including $2 billion of previously announced acquisitions. Further, the company will accelerate the sale of underperforming assets. The sale of these underperforming assets could be up to $15 billion in 2014-2015, according to the new CEO.
It did not take long for investors to see that Shell carries out the new strategy. Shell announced that the company reached an agreement with Kuwait Petroleum International to sell its Italian downstream business on Thursday February 20, 2014. Both companies did not disclose the sale price. The next day, Shell announced another agreement with Vitol and Abu Dhabi Investment Council to sell its Australian downstream business for $2.6 billion. Finally, Reuters reports that Shell is likely to sell its Nigerian assets to trading house Glencore (OTCPK:OTCPK:GLCNF, OTCPK:OTCPK:GLNCY). Investors were pleased to see that Shell adopted the new strategy immediately and the shares surged 3.60%.
Chevron Corporation's strategy
In contrast to Shell's new strategy, Chevron announced that the company will stick to its initial strategy. Chevron will spend over $40 billion/year for the next couple of years to develop new oil and gas fields. The company seems confident that its strategy will increase production and stop revenue from falling even further. However, it will take some time before several of Chevron's major projects are fully operational. For example, the Gorgon project and Wheatstone projects in Australia will take time to complete. The Gorgon project is only 76% complete after four years of execution and the Wheatstone project will take even longer to complete. In the meantime, investors should keep their patience and enjoy Chevron's attractive dividend yield (yield: 3.50%) and large share buyback program.
Because Chevron decided to stick to its initial strategy, the company has several issues to solve in 2014. The rising production costs and capital expenditure to develop new oil fields remain major threats to the company's profitability. Chevron announced several setbacks during the fourth quarter of last year. The company put its $10 billion Rosebank project on hold due to rising costs. Even more worrying is the Australian Gorgon project. Chevron announced: "The latest estimated cost is $54B, vs. a $52B estimate offered a year ago and $37B when the final investment decision was taken in 2009." Finally, Reuters reported that Chevron's $6.4 billion project in China faced another setback. A disagreement with partner PetroChina (PTR) is reported to be the cause of the setback.
Now, there are two major oil and gas companies and both have different strategies. Shell is looking to sell low-yielding assets and decrease its capital expenditure while Chevron committed to keep sending large amounts of money to develop new fields. In my opinion, Shell's strategy makes the most sense. It seems that Chevron focuses more on production and revenue growth and Shell focuses to increase profitability. In the end, it is the company's profit and free cash flow that will attract investors.
Look at ConocoPhillips (COP). This company is the only Oil & Gas major to deliver strong fourth quarter earnings and beat analyst expectations. ConocoPhillips introduced a plan to sell low-yielding assets and concentrate on more profitable operations in North America. This strategy seems to have worked out:
Analysts say COP's plan to sell lower-yielding assets to focus on more profitable oil production is beginning to pay off as the industry faces pressure from shareholders to lift returns despite flat oil prices and rising costs for risky exploration work designed to replace reserves.
Shell will divest $15 billion of its low-yielding assets and decrease the level of spending. Further, the company increased the focus on the profitability of its worldwide projects. Shell took immediate steps and sold several assets in Australia and Italy. Therefore, I am confident that the new CEO will execute Shell's strategy as he announced. On the other hand, Chevron keeps spending billions of dollars on low-yielding projects. In 2012 and 2013, this strategy did not deliver the expected results. Chevron has bet massive on a couple of large projects. As a result, the company will grow its production and revenue eventually. However, the costs of these projects keep on rising. This could harm the company's profitability. Overall, I favor Shell's strategy over Chevron's strategy. Shell is on track to improve profitability, while I doubt that Chevron is able to grow profitability substantially.