The recent developments in the oil market have proven to be a boon for oil prices as Brent oil is now trading at more than $56 per barrel. The good news is that Brent oil is expected to go much higher next year and might even exceed $60 per barrel as more positives have emerged in the oil space. This is great news for the likes of Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) as the company has made impressive progress in recent years to bring down its upstream costs.
So, in this article, we will take a closer look at what the $60 per barrel oil price scenario means for Shell. But before jumping into the details, let me explain why oil is set to exceed the $60/barrel barrier next year.
Why the $60 oil price barrier is set to be broken?
A few days ago, OPEC struck a deal under which it will be reducing its production by 1.2 million barrels per day for the first half of 2017. Now, this week, non-OPEC nations announced that even they will be reducing the oil output by an additional 558,000 barrels per day. Therefore, a total of 1.8 million barrels per day of production is set to be slashed in 2017 on the back of the recent agreements.
As the production cuts take place, oil prices will also be boosted by an increment in demand. According to the International Energy Agency, global oil demand will grow by 1.2 million barrels per day next year. This means that the oil market will witness a supply deficit of around 600,000 barrels per day in 2017.
This will lead to a reduction in oversupply in the end-market, as a result of which the price of the commodity will rise further. In fact, Bank of America forecasts that oil could rise to as much as $70/barrel by the middle of next year, but even if we take a more conservative view, it won't be surprising if oil exceeds $60 per barrel going forward as industry watchers indicate.
If oil averages more than $60 per barrel next year, which seems quite likely, Royal Dutch Shell will be in a strong position to improve its financial performance. Let's see why.
Why Shell is well-placed to benefit from improved pricing
The upstream business of Shell is already progressing in the right direction even in a weak oil pricing environment. Last quarter, for instance, Shell managed to post a profit of $4 million in the upstream segment as against a massive loss of $582 million in the prior-year period. This massive improvement in the upstream profit was in spite of an 11% drop in the oil price over the same time period.
This improvement in Shell's bottom line despite lower oil prices indicates that the company has managed to bring about a strong improvement in its cost profile. As a result of this it can post a stronger bottom line performance despite lower pricing.
Now, the increase in Shell's upstream earnings despite lower pricing is not surprising. This is because the company's new production assets have very low cash costs. In fact, according to Shell, the new projects that will go online between 2014 and 2018 will have cash costs of only $15 per barrel.
At this level of operating costs and a 35% statutory tax rate, Shell is of the opinion that the new production will add $10 billion to its annual cash flow from operations at an oil price of $60/barrel. This is not surprising as Shell forecasts a drop in its operating and capital costs going forward as the new projects come online, which will make them cash accretive. This is shown in the chart below:
Source: Royal Dutch Shell
Thus, at a $60 price level, Shell's new production will boost its operating cash flow going forward quite substantially.
The improvement in oil prices will prove to be a tailwind for Shell's financial performance going forward, as the discussion above indicates. So, as oil looks set to break the $60 pricing barrier, Royal Dutch Shell looks set to deliver more upside. As such, remaining invested in the stock for more gains will be a prudent move given the recent developments in the oil market.
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