Shell Shares Crash: COVID-19 Breaks The Super Major Business Model
- In continuing a review of oil majors and the impact of government Covid-19 responses to their business models, we look at Shell.
- Shell cut its dividend for the first time in 70 years.
- More cuts should be coming by other majors.
- Shell's poorly timed acquisition of BG was disastrous.
This is the second of what may be a series of articles regarding the stresses on the Super Majors' integrated business model. The starting point remains similar, but super majors businesses are cracking in different ways. Ultimately, their dividends are unsustainable, their capital efficiencies are challenged at best, and the world needs much higher oil and much better management of oil and gas assets across the value chain. Shell (RDS.A RDS.B) displayed this recently with their 66% dividend cut, the first cut in 70 years.
But first, the background from my article Covid-19 Breaks the Super Major Business Model - Chevron is an Avoid is a good starting point:
With oil near its 100 year inflation adjusted low in the midst of government mandated demand shut down, investors are looking for ways to get upside exposure to a rebound in price. Speculative interest has intensified as the broader market has rebounded. Open interest in poorly structured oil ETFs like USO (USO) and oil equity ETFs like XLE (XLE) has spiked. And the combination of ETF and company specific buying has propped up the shares of integrated oil super-majors like Exxon (XOM) and Chevron (CVX).
Integration historically provided super majors like Exxon and Chevron an economic buffer from the cyclicality of the industry, going back to the days of Rockefeller at Standard Oil. Controlling much of the value chain through "integration" meant that in oil price booms, the majors could cash in on their oil production. While in price busts, midstream revenues could remain steady and refining, chemicals and/or retail (gas stations) could generate excess cash flow - driven by increased demand and margins from lower priced oil and products.
The business model was brilliant and innovating and implementing it made Rockefeller the "richest person ever." However, it did not build in a contingency for the concurrent demand and supply shock of the worldwide policy response to the novel Coronavirus and OPEC+ price war. The rapid demand shock collapsed product demand and refining and chemicals margins, is likely to disrupt midstream operations. And the combined demand shock and oil production increase sent oil production activities deep into the red. The concurrence of these may break the integrated super-major business model.
Shell is both similar to and different from Chevron and Exxon, and as a $125 billion company it is worth exploring those differences and where their implementation of the integrated business model they helped pioneer went wrong.
One big difference between Shell and Exxon / Chevron is the much larger focus on LNG. Shell acquired British Gas in 2016 in a $53 billion deal that accelerated its LNG operations and made it the second largest publicly traded oil and gas company at the time by market capitalization, second only to Exxon.
At the time, the company said it would "cut thousands of jobs from the combined group and sell $30 billion of assets over the next three years in order to finance the deal, buy back shares and support dividends, which it has vowed to maintain or increase." Ironically, a few years later, with global LNG prices at multi-year lows, Shell was forced to cut that dividend by 66%.
Source: Bluegold Research
Incidentally, global LNG markets and demand were looking weak even before Covid-19, as illustrated in a recent presentation by Shell. And the demand outlook is even weaker now:
Sources: Shell, IHS Markit, Poten & Partners, S&P Global Platts Wood Mackenzie
Another chart from that same presentation illustrates another aspect of the integrated business model failing to provide earnings support in a low oil price environment - low demand for refined products:
As discussed in the first article in this series, the purpose of the integrated Super Major business model is to offset cyclicality in the commodity oil and gas industry through exposure to multiple parts of the value chain. When oil prices rise, excess earnings are achieved in the upstream part of the business, while demand for gasoline and other refined products falls and margins in refining are squeezed. And when oil prices fall, demand for refined products is expected to rise and margins are expected to improve.
In the context of the worldwide policy response to Covid-19, oil prices have fallen AND demand for refined products have fallen, crushing this integrated model. The super majors expanded their business lines to include LNG production, export and delivery. Shell in particular had focused on this through their acquisition of BG discussed above and of Repsol's LNG business previously for $5.7 billion.
The addition of the LNG component has proved to be similarly cyclical and unfortunately for Shell and the other super majors, demand proved sensitive to some of the same factors of demand for oil and for refined products. Shell, being the most exposed to this factor in particular, may be the proverbial canary in the coal mine. Shell's 66% dividend cut, necessary on the back of collapsing pricing across Shell's major business lines including LNG, may be the first of many.
It is worth highlighting a chart from Chevron's March presentation, where Chevron helpfully displayed the oil price necessary to sustain the dividends of the super majors. Chevron represents their dividend as the best supported, requiring $55 oil. It shows BP (BP), Exxon, Shell and Total (TOT) requiring even higher prices. The super majors have tapped the bond markets, perhaps to fund this dividend gap. But even Shell's recent issuance of debt was insufficient to sustain its dividend at prior levels, perhaps a signal that it is a matter of time before others cut:
And to see why this matters, it is worth observing Shell's recent performance vs peers leading up to and then after the announced dividend cut:
The market is trading Shell like it is uniquely unable to pay its dividend, and it reacted with substantial under-performance for Shell shares after the cut. However, as shown in the Chevron presentation chart above, each of the super majors may be borrowing to sustain their dividend in a sub $55 oil price environment. Borrowing to pay a dividend can get ugly - if oil prices don't recover rapidly and substantially, debt levels could be expected to rise, potentially followed by a dividend cut even more poorly received due to the delay.
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