Royal Dutch Shell's Recovery Will Strengthen The Rally

| About: Royal Dutch (RDS.A)

Summary

Royal Dutch Shell’s upstream business has struggled on account of lower oil price realizations, but this is about to change going forward.

With Brent now hovering around $50, the average price of oil has improved in the second quarter and this will help Shell improve its realizations in the upstream.

Shell’s upstream performance could improve further as higher inventory drawdown on the back of weakening production and stronger demand will lead to higher prices.

Shell has improved its efficiency and geared its business to generate higher free cash flow and ROCE at lower oil price levels, which is another tailwind apart from stronger pricing.

Even though Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has made an impressive recovery on the stock market in the past few months, the fact that its results, both in the downstream and the upstream segments, have taken a beating cannot be denied. In fact, Shell's earnings were decimated badly when it last reported its results last month, witnessing a drop of over 56% on a year-over-year basis.

However, when Shell releases its next set of results, the rally in the stock will gain more momentum as the prospects of the upstream business have improved impressively of late. Let's see why.

A look at problems in the upstream business

The upstream business of Shell had witnessed a deeper loss of $1.4 billion last quarter, driven by an equivalent decline in oil and gas price realizations. In fact, Shell's cost savings were not enough to bring about a major turnaround in this segment, as shown in the chart below:

Source: Shell

From the chart above, it is evident that a recovery in oil prices is needed in order for Shell's upstream business to gain momentum. Now, the good thing is that oil prices have recovered remarkably in the ongoing quarter as compared to the first quarter of 2016. This is shown below:

Click to enlarge

Source: Bloomberg

Brent oil prices are now closing in on $50 a barrel, and as a result, the average price of oil in the current quarter is higher than the previous one. This will help Shell bring about an improvement in its oil and gas price realizations going forward. What's more important to note here is that oil prices are likely to continue improving going forward as oil inventories have been declining on the back of higher inventory draw, which is a result of strong demand and lower production.

Positives are emerging in the upstream business

For the week ending June 24, crude oil stockpiles in the U.S. dropped by 4.1 million barrels, comfortably exceeding the analyst forecast for a drop of 2.4 million barrels. More importantly, this decline in crude oil inventories is being seen on a consistent basis as inventories have dropped for six weeks on the trot now.

This drop in oil inventories in the U.S. is being driven by a drop in production and higher demand. Last week, crude oil production in the U.S. was down by 55,000 bpd, higher than the preceding week's decline of 39,000 bpd. Moreover, the decline in U.S. oil production and inventories is also being aided by a global drop in oil supplies.

In fact, as the EIA reports, global oil output was down by 590,000 bpd on a year-over-year basis in May after an increase of only 50,000 bpd in April. A major factor contributing to this massive drop in oil production last month was an 110,000 bpd drop in OPEC production. Going forward, it is anticipated that production will continue to drop with non-OPEC decline for 2016 tipped at 800,000 barrels per day.

On the other hand, problems in the OPEC could create a production shortfall in the coming year with demand exceeding supply. As reported by Bloomberg:

"By the end of next year, OPEC will need to pump nearly 1 million barrels above last month's production level to keep the market in balance, according to Bloomberg calculations based on IEA data. Fulfilling the IEA's forecast would require OPEC to overcome some major hurdles. In Nigeria, oil production has slumped to a 28-year low of 1.37 million barrels a day -- about 480,000 below its full capacity, IEA data show.

Libyan output remains just a fraction of the 1.6 million barrels a day pumped before the toppling of Moammar Qaddafi in 2011. The nation pumped 270,000 barrels a day in May, a decrease of 80,000 from the previous month as a dispute between rival governments in the west and east halted tanker loading at the port of Hariga for several weeks."

Similarly, economic problems in Venezuela are also expected to hurt oil production by 100,000 barrels per day in 2016. Thus, a combination of lower supply and increasing consumption will help the oil market attain balance, as shown below, and lead to an increase in prices:

Source: EIA

Thus, an improvement in oil prices will help Shell improve its oil price realizations going forward, and this will prove to be a tailwind for the upstream business. As we had seen earlier in the article, weakness in oil prices was the most important reason why Shell's upstream business had taken a hit last quarter, despite the company achieving $300 million worth of cost savings.

Now, as Shell is intent on achieving further cost savings by reducing its workforce further, which accounts for 40% of its operating expenses, its performance in the upstream should continue to improve. In fact, Shell has decided to enhance its free cash flow from operations to a range of $20 billion-$25 billion by the end of the decade, achieving a return on capital employed of 10% in a $60 oil price environment.

Considering the fact that Shell's average free cash flow came in at $12 billion from 2013 to 2015 and return on capital employed averaged 8% in a $90 pricing environment, it is evident that the company has made impressive progress on the cost reduction front to enhance returns. As the oil price increases further, it will be able to leverage its cost efficiencies to deliver improved results.

Conclusion

Thus, going forward, it won't be surprising if a recovery is seen in the upstream business of Shell. A recovery in oil prices, coupled with the company's moves to improve efficiency will lead to a stronger financial performance in the future, which is why investors should continue to accumulate Shell shares for the long run.

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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.