Royal Dutch Shell: Takeaways From Q4 Results

About: Royal Dutch Shell plc (RDS.A), RDS.B
by: Power Hedge

Royal Dutch Shell generally saw stronger results than a year ago.

Rising production and liquids prices both stimulated revenues and free cash flow.

The company saw LNG volumes increase, helping to support our bull thesis on that market.

The company's reserve development was very disappointing and it drops the three-year average under 100%.

Free cash flow was propped up by working capital movements, but it was still sufficient to more than cover the dividend.

On Thursday, January 31, 2019, oil and gas supermajor Royal Dutch Shell (RDS.A) (NYSE:RDS.B) announced its fourth quarter 2018 earnings results. As was the case with many other large energy companies, these results were overall better than what the company had last year, although the company was certainly affected by the market turbulence that we saw in the fourth quarter as the numbers were arguably worse than in the third quarter. There were certainly some good things here, though, notably the large upward surge in free cash flow that took place in both the year-over-year and quarter-over-quarter periods. Overall, shareholders in Royal Dutch Shell certainly have a lot to like here, although there is one area in which I continue to have concerns.

As my long-time readers are no doubt already well aware, it is my usual practice to share the highlights from a company's earnings report before delving into an analysis of its results. This is because these highlights provide a background for the remainder of the article and serve as a framework for the resultant analysis. Therefore, here are the highlights from Royal Dutch Shell's fourth quarter 2018 earnings results:

  • Royal Dutch Shell brought in total revenues of $104.626 billion in the fourth quarter of 2018. This represents an excellent 18.73% increase over the $88.124 billion that the company brought in during the fourth quarter of 2017.
  • The company reported an operating cash flow of $22.021 billion in the fourth quarter. This compares very favorably to the $7.275 billion that the company reported in the year-ago quarter.
  • Royal Dutch Shell produced an average of 2.809 million barrels of oil equivalents per day during the most recent quarter. This compares favorably to the 2.775 million boe per day that the company reported during the prior-year quarter.
  • The company saw LNG liquefaction volumes increase by 3% year over year and LNG sales volumes increase by 1% year over year. This supports the LNG investment case that I have been presenting over the past several months.
  • Royal Dutch Shell reported a net income of $5.646 billion in the fourth quarter of 2018. This represents a 43.41% increase over the $3.937 billion that the company reported in the fourth quarter of 2017.

It seems likely that one of the first things that anyone reading these highlights will notice is that Royal Dutch Shell's revenue increased significantly compared to the prior-year quarter. One of the major reasons for this is that both oil and natural gas prices were broadly higher than they were a year ago. This remains true despite the near 40% decline in oil prices that occurred during the period. However, the company did end up with lower liquids realizations than in the third quarter (although natural gas prices were significantly higher):

Q4 2018 Q3 2018 Q4 2017
Global Liquids Realized Price ($/bbl) $59.89 $68.21 $55.28
Global Natural Gas Realized Price ($/kscf) $5.75 $4.92 $4.44

It should be fairly obvious how the improved pricing environment would result in higher revenues for Royal Dutch Shell. This is because the higher prices result in the company receiving more money for each unit of oil or gas that it sells.

All else being equal, this alone would boost revenues. However, all else is rarely equal in the business world. The most obvious thing that could cause this to not be true is a production decline. After all, if a company sees its production decline, then the fact that it has fewer goods to sell could cause its total revenues to drop even if prices were higher. Fortunately, though, that was not the case here. As noted in the highlights, Royal Dutch Shell reported an average upstream production of 2.809 million boe/day in the fourth quarter compared to 2.775 million boe/day a year ago. Royal Dutch Shell credits new field start-ups and ramp-ups for this increase, although it does not name any fields. However, it is worth noting that the company's production growth would have been much higher had the company not continued to divest producing assets during the quarter as its production would have jumped by 5% year over year had it not done this.

One of the most important, if underappreciated, tasks for an oil and gas company is discovering or otherwise acquiring sufficient oil and gas to replace the quantity that it pulls out of the ground and sells. This is because the oil and gas industry is an extractive one by its very nature and therefore a company that fails to replace the resources that it pulls out of the ground will eventually run out of resources to sell. This is a concern that I have had about Royal Dutch Shell for quite some time as the company has not been performing well in this area. This problem reoccurred in 2018 as the company managed to discover or acquire approximately 700 boe by extracted about 1.4 billion boe from the ground. The company therefore believes that it had a reserve replacement ratio of 53% in 2018 and 96% for the three-year period ended in 2018. While the company has been working to expand its position in renewable energy and other alternative power areas, this is still a disturbing situation that could pose problems for the company's long-term sustainability if it does not resolve this problem soon.

One of the most attractive things about Royal Dutch Shell in the minds of many investors is the historically large dividend that the company pays out to its shareholders. For this reason, investors will likely be pleased to see that the company managed to grow its free cash flow significantly over the year-ago quarter. During the fourth quarter, Royal Dutch Shell reported a free cash flow of $16.709 billion compared to $6.610 billion in the fourth quarter of 2017. The reason why this is important is that free cash flow is essentially the money that is left over after a company pays all of its bills and makes all necessary capital expenditures; thus, this is the money that the company can use for things such as paying off debt or paying dividends to shareholders. It is important to note, though, that approximately $9.1 billion of the increase came from working capital movements derived from lower inventory levels and lower crude prices. If we exclude this, then the company would have had a similar free cash flow to its year-ago level, which is still decent but definitely less impressive than what it actually reported.

The company's free cash flow also appears to be more than enough to cover its dividend payments, which is certainly nice to see. At the fourth quarter's dividend rate of $0.47 per common share, flat from last year, Royal Dutch Shell distributed a total of $3.869 billion to its common shareholders. Clearly, this is well below the company's free cash flow. It did use another $2.533 billion to repurchase its own shares, which does bring us close to the level that it had in free cash flow if we exclude the changes in working capital. With that said, though, share repurchases are entirely voluntary payments and it does not appear that the company is having any trouble making its distributions to shareholders.

In conclusion, this was certainly a reasonable quarter for Royal Dutch Shell. The company showed positive year-over-year and quarter-over-quarter production growth and we saw the company derive some benefit from the improving market for liquefied natural gas. The biggest problem here is that the company continues to struggle at replacing the resources that it pulls out of the ground. This is something that it will need to correct.

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.