Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has managed the adversity in the oil and gas pricing environment quite impressively. The oil major has shifted its focus into areas where it can generate stronger returns from its assets. Liquefied natural gas, or LNG, is one such area where Shell has been focusing in an aggressive manner of late.
In fact, during the oil downturn, Shell's LNG business has held steady as the earnings of its integrated gas business increased 7% on a sequential basis last quarter. Additionally, on a year-over-year basis, the earnings from the integrated gas segment remained constant due to strength in LNG. So, it is not surprising to see why Shell is increasingly focusing on the development of its LNG segment.
Why Shell is increasingly focusing on LNG
In my opinion, Shell is doing the right thing by enhancing its LNG volumes. This is because the price structure of LNG contracts seems favorable for Shell. This is shown in the charts below:
As shown in the charts above, there are a number of factors that are expected to keep LNG prices strong. As the first chart shows, an LNG contract in Asia tracks oil prices very closely due to the proximity in oil parity. Oil parity indicates that LNG price that equates to a barrel of oil equivalent. If the price of LNG is higher than crude oil, it means that the oil parity is broken, though a co-efficient of 0.1724 indicates complete oil parity.
Now, in Asia, LNG is sold at a full-oil parity that's 17% lower than the oil price, according to the co-efficient pointed out above. What's more, the pricing also includes shipping, so Shell does not have to incur extra costs for shipping LNG into Asia. Additionally, there are price protectors that Shell enjoys in the Asian LNG market.
As the second chart in the image given above shows us, Shell can set a floor and ceiling for LNG prices beyond certain points. This allows the company to protect both itself and its counterparties from high and low oil pricing. Hence, there are a number of positives for Shell to carry out aggressive investments in the LNG business, which is the reason why the company has been bumping up its volumes impressively over here.
For instance, Shell's LNG volumes in the last reported quarter grew 45% to 7.70 million tonnes as compared to LNG volumes of 5.31 million tonnes in the third quarter of 2015. This growth in the LNG volumes was primarily driven by the BG acquisition, which added nearly 2.19 million tonnes of LNG liquefaction volumes.
Shell's LNG segment will drive cash flow growth
More importantly, Shell seems to have completed the majority of its investments in the LNG segment. This is the reason why the company is now well-placed to generate strong cash flow from this segment as it was one of the first movers in this segment. In fact, both Shell and BG combined had taken most of their final investment decisions in the LNG segment by 2011, while peers started getting in on the game 2012 onward, as shown below:
Due to this move, Shell has brought a majority of its LNG assets into service while very few are still under construction. This is evident from the following pie chart:
Source: Royal Dutch Shell
This is a clear indication of the fact that Shell's LNG business will now start generating robust cash flow for the company going forward as the company has completed most of its capital investments in this segment. The following chart shows the expected free cash flow generation and the expected return on capital employed from Shell's integrated gas business:
Source: Royal Dutch Shell
As shown in the table above, Shell's integrated gas division is expected to generate around $5 billion in free cash flow per year starting from 2019 to 2021, up from $4 billion of free cash flow the company produced from 2013 to 2015. The important thing to note here is that Shell will generate this level of free cash flow at an oil price of $60 per barrel, which is a remarkable improvement as compared to the oil price of $90 per barrel in the previous cycle.
Now, keeping the oil-parity chart in mind, it is evident that Shell will be able to generate higher free cash flow at a lower LNG price, which is not surprising as the company has completed most of its investments in this segment. In fact, Shell will be bringing online most of its LNG supply over the 2016-17 timeframe.
For instance, so far this year, Shell has added around 3.9 million tonnes per annum of new LNG production to its portfolio. It remains on track to bring online approximately 3 million tonnes per annum of new capacity in 2017. The following chart shows Shell's roadmap in the LNG segment:
Another key reason behind Shell's higher free cash flow in the LNG segment is its involvement in almost every stage of the LNG value chain, including exploration, extraction, and LNG liquefaction. In fact, Shell is also involved in turning the LNG back into gas and distributing it to customers. At the same time, the company is expanding its footprint into new countries, which should bolster its integrated gas division going forward. At present, Shell has LNG supply projects in more than 10 countries around the world.
Source: Royal Dutch Shell
As the chart above shows, Shell has the second-largest liquefaction capacity in the industry, which has allowed it to bring about an improvement in both sales and liquefaction volumes of late. Thus, Shell's strong positioning in this business will prove to be a growth driver for the company going forward and have a positive impact on the company's cash flow generation.
Royal Dutch Shell's LNG business will prove to be a strong growth driver for the company in the long run as the points discussed above indicate. The company will witness stronger cash flow generation since it has completed the majority of its investments in this segment. So, it will be a good idea to remain invested in Royal Dutch Shell since strength in the LNG business will prove to be a key catalyst in the long run.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.