Beyond the recent hype created by the Saudi events, there is a trend of steady and sustainable advance in the price of oil, which I believe is likely to continue for as long as the current global economic cycle that started with the 2009 economic recovery is going to persist. In fact, I believe that the trigger for the next economic downturn will be an oil price spike, perhaps very similar to what we saw in the 2007-2008 period. This is how I saw the situation play out back in late 2015, which is when I decided to buy Shell's (RDS.A) (NYSE:RDS.B) stock, along with Chevron (CVX) and Suncor (SU). It is a long-term bet on a trend that I am certain will happen, although the timing of it was never something I was as certain of, which is why I opted to buy only solid names, with a diverse portfolio of projects.
The fact that collectively these three stocks I bought in late 2015, early 2016 provided an average dividend of about 5% was also a deciding factor. I figured if I have to wait years, through quite a bit of uncertainty and volatility for the trend I decided to play to reach its final destination, then I might as well get paid while I wait, while waiting with my investments in relatively secure companies, which are not likely to disappear or have their market cap reduced to nothing in case that oil price weakness lasts for longer than I expected. As I continue to wait, satisfied with the results of the first leg of the oil price recovery when it comes to my position in Shell, I am looking forward to reaping the results of the next two legs in what is a secular bull market in oil, which will likely go on for a few more years. Although, we should keep in mind the fact that this bull trend will be far more volatile that what we are used to.
Shell's profitability prospects
2015-2016 was perhaps one of the worst period so far this century for the global oil & gas industry. We had the 2009 experience when oil prices cratered, but we should keep in mind the fact that it was a very short dip and the fact that it came down from a very high price point and climbed back up into the $100/barrel range within a relatively short period of time.
Shell also had its terrible period, which came just on the heels of its BG merger deal, which was widely proclaimed to have been a mistake due to Shell over-paying. It is true that if it would have waited a while longer, it probably would have been able to get the deal done for much less, and indeed, it would have been far more advantageous. But as I pointed out on many previous occasions, I do not see the deal as being overall a net negative for Shell in the longer term. With 2016 having been a relatively bad year for the entire industry, Shell still managed to stay overall profitable. Looking at the first nine months of this year compared with the corresponding period from last year, operating profits tripled from $3 billion to $9 billion. For the quarter-on-quarter comparison, we have operating profits of $4.1 billion in the third quarter, compared with $1.5 billion in the previous quarter. This, in my view, is a testament in regards to what a big difference a small increase in oil & gas prices can make to Shell's results.
Revenue increased by 30% during the same period, which in effect shows that there was a roughly 10% increase in operating profits for every percentage point increase in revenues. One of the reasons why this is the case is because the upstream segment is finally entering into profitability territory in terms of oil & gas prices. For the first time in a while, Shell reported a net operating profit of $575 million, while for the year, it is still down by $499 million for the upstream sector. When excluding capital expenditures related to the BG acquisition, capital spending declined from $16.4 billion for the first nine months of 2016, to $15 billion for the corresponding month of this year. In other words, Shell adjusted its capital expenditures downwards, even as higher oil & gas prices are driving revenues higher.
Looking forward, there is one very important aspect of Shell's overall business, which is in fact in part the result of the BG merger. It is an aspect that I liked from the very beginning when the merger was announced and I continue to like it, especially now that the global oil & gas market is starting to show signs of starting the second leg of the recovery. I am particularly excited about the prospects of Shell's dominant position in LNG. As we know, natural gas prices in the old world are set in large part by long-term pipeline supply agreements. Shell has plenty to be happy about in this regard, given that it does have significant pipeline gas contracts in Europe and elsewhere around the world, and the advance in oil prices will also cause natural gas prices to go up, which might not be the case in North America. While this is all good news for Shell, the fact that the LNG market is showing strong signs of recovery is starting to look like really good news for Shell.
In my personal view, the longer-term global energy picture is one of more reliance on natural gas than most forecasts currently would suggest. Even Shell's outlook in this regard is too conservative in my view.
I think at some point during the first half of this century, natural gas will become the most important energy source on the planet. If that is true, it will need to have a lot more supply flexibility than it does currently, given that supply is dominated by pipelines. The only way that the supply security issue can be addressed worldwide is to have a robust LNG industry complementing the rigid pipeline system. In this respect, Shell is a global leader and LNG production increased by 11% for the first nine months of this year compared with last year. With new potential uses for LNG, such as in marine transport, in addition to the already growing need to have LNG as a way of keeping natural gas supplies flexible and diversified, this leadership role is likely to prove to be a valuable long-term asset within Shell's portfolio.
With growing production of LNG, while in the shorter and in the longer term prices are set to increase due to growing global demand, which by some estimates might be twice the rate of overall natural gas demand increase, Shell is in my view a great way to participate in the LNG story, given that it also has its robust downstream segment, which provides a hedge against the many bumps along the way, which I am sure will be a part of the longer term story. As was the case with the recent oil & gas price collapse, Shell's downstream operations will keep the company afloat during such bad times, while its other segments will struggle, including its growing LNG segment, while the same may not always be the case with some of the companies that are pure LNG players. With the potential for growth coming from LNG, while its downstream operations provide a hedge against bad times that may potentially be on the way, Shell is the oil major that one can own and expect relatively nice gains as the oil & gas market continues to recover, while at the same time it provides enough comfort that one can sleep at night, not having to worry about the next what if.
Disclosure: I am/we are long RDS.A, SU, CVX.
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.