Royal Dutch Shell's Big Gamble: The Long Case

| About: Royal Dutch (RDS.A)

The oil production industry is dominated by large national companies (Think Saudi Arabian Oil Co.). For those of us interested in Western corporations, there are a few remaining (albeit much smaller) contenders. In order of size by reserves they are: Exxon-Mobil (NYSE:XOM), BP PLC (NYSE:BP), Chevron (NYSE:CVX), Royal/Dutch Shell (NYSE:RDS.A), Conoco Phillips (NYSE:COP), and Total SA (NYSE:TOT) (Petro Strategies, Inc.).

The oil industry in general presents a very attractive investment option for the near future. These companies are valued very conservatively, all at or below 10x earnings. This contributes to their ability to pay dividends on the order of 4% or greater. Unlike many businesses which are struggling to increase costs, like Kraft (KFT) or Procter & Gamble (NYSE:PG), oil companies readily pass the higher price of gas on to consumers who are used to a variable price at the pump. In an environment of inflation, the value of these companies' existing reserves will rise, and their sale prices will rise too. This will allow them to continue to generate shareholder value at a time when the real price of many other stores of value will be falling.

Royal Dutch Shell stands out as a strong contender for the 2012 - 2015 period. The company is embracing the relative economic stability we have seen over the past few years and is expanding its upstream oil operations. Below are the company's capital expenditures for the past five years, as well as its 2012 target.

Est 2012

2011

2010

2009

2008

2007

>$30B

$26.96B

$23.68B

$28.88B

$31.42B

$16.44B

(Source: 2011 Annual report and company website)

Click to enlarge

According to the company, over 80% of 2012 capital expenditures will be upstream, reinforcing the company's commitment to grow its base of reserves and keep its reserve replacement ratio above 100%. These operations promise cash flows for the period 2012 - 2015 30%-50% higher than the period 2008 - 2011. The company bases these assumptions on a Brent Crude price of $80 - $100 a barrel. With oil now well past the $100 mark, the company seems conservative in is estimates.

The expenditures are diverse in their nature, with exploration in areas as close to home as the north sea and as exotic as the Niger delta and middle east. The company is also investing in different types of energy, including traditional land basins, deep-water wells, and tight gas and liquid rich shale. In order to distribute all of this new production, the company is investing in its Port Arthur downstream refinery expansion project.

These bold expenditures do beg the question of whether or not such large expense can be justified in this economic climate. However, they might also be a wake-up call for the rest of the industry. Global demand for energy is constantly increasing, and the weak spending environment of the past few years has left many opportunities open. If Shell makes investments now, they should pay off handsomely in the coming years.

Additionally, these expenditures come in relative moderation to the sudden increase in from 2007 to 2008. The decision to begin spending now allows the company to spread out its expenditures rather than have to vamp up rapidly should the energy market continue to improve.

While these expenditures leave the company vulnerable to economic contraction, they also present large opportunity. And, they make Shell unique. The company is a play on improvements in the industry, and its spending policies means that its shareholders will feel the full benefits of these improvements. In the meantime, the well-covered dividend makes waiting for the returns from the new projects a very pleasant process.

Disclosure: I am long PG.