Shell's Much-Publicized Green Plan Should Not Worry Investors
- Shell's massive pivot away from oil & gas production and into green energy is motivated by its lack of ability to replace oil & gas reserves.
- At the root of Shell's inability to maintain oil & gas reserves is the fact that, unlike many peers, it tends to shun projects like shale, which are less profitable.
- Shell's upstream segment is set to shrink but it is also likely to be more profitable compared with many of its industry peers.
- The plunge into the green energy boom may seem financially risky, but Shell could benefit from government support for the industry.
- Shell's core business will be neither its upstream oil & gas production, nor its growing green sector, but rather its LNG and petrochemicals sectors, where the outlook looks bright.
In its February strategy outline, Shell (RDS.A, RDS.B) announced a set goal of zero net emissions from its operations by 2050. With the target being three decades away, it resembles pie in the sky ambitions at first, but it is nothing of the sort. It also outlines goals and projections that are very relevant for the current decade. As a Shell investor, my first reaction was to think of an exit strategy, because the new vision of Shell as presented by its current leadership does not necessarily fit in with my view of where this company needs to be headed. But then, once I took a step back and remembered that such company pronouncements are no longer what they used to be, given the shifts in Western society & culture, I decided that at least for now, it is still worth sticking with Shell stock. The key is not so much that I do not believe that Shell will execute on its declared strategy of shifting its business more towards EV charging stations, wind farms, and so on. It has more to do with the wider picture, which does not correspond to the reasons given by Shell to transition to a green energy company.
Shell increasingly unable to replace its oil & gas reserves
The first clue in regards to Shell having some severe reserves issues was more than a decade and a half ago when it sliced its reserves estimates by 20%. Since then, the trend was unmistakable. Shell is slowly running out of reserves.
I should note that the bump in reserves that happened from 2015 to 2016 was the result of the merger with BG Group. That is why it did not lead to an improvement in the years of reserves left, even though the absolute volume of reserves did increase.
Based on the considerations I presented so far, one would think that this is a no-brainer in terms of declaring Shell stock as an investment that should be sold with no hesitation, perhaps in favor of competitors that managed to maintain their oil & gas reserves much better. In this respect, its American rivals Exxon (XOM) and Chevron (CVX) are doing much better. Canadian oil sands miner Suncor (SU) looks even better.
Source: Seeking Alpha.
Peak oil demand theorists might argue that Shell's troubles with reserve replacement should not be concerning, because after all, eventually reserves will only get stuck in the ground as demand for oil & gas will disappear, which will make those reserves worthless at some point, in the not too distant future. I recently wrote an article that disagrees with that outlook being an imminent reality: "Norway's Oil Demand Data Is A Cold Shower For EV-Driven Peak Oil Demand Proponents", which provides a detailed explanation in regards to why I consider forecasts of a peak in global oil demand to be premature. So the reserve issue does matter in many ways, but it should not be viewed simplistically. It is not just a matter of replacing a barrel for another barrel, because when it comes to profitability, not all barrels are equal.
There is value and opportunity in Shell stock, despite its pledge to pivot to less profitable green initiatives and its failure to maintain its oil & gas reserves volume
So far we established that Shell has not been as successful as many of its peers at reserve replacement. It is also looking at investing massive amounts of money in energy sectors with questionable profitability profiles. It is not exactly an enticing investment story. We should take a step back and try to make sense of it all in order to better understand Shell's overall long-term strategy, which may not be perfect, but it does make some sense.
Shell did indeed fail to replace its reserves for many years now. A sharp decline in upstream oil & gas production will follow throughout this decade. One aspect where it does not lose out is in regards to its debt situation. Last year was a rough one for oil & gas producers.
Data source: Shell, Exxon, Chevron.
Shell's debt increased by 12%. Exxon's debt increased by 80%, and Chevron's debt by 64%. This by itself does not say a lot, but as we can see, in absolute dollar terms both major competitors had an increase that is roughly double the increase that Shell experienced. In terms of debt/revenue levels, Shell stands at 50% for 2020, Exxon at 26%, and Chevron is at 47%. While Shell's overall debt situation is the worst of the three, its trajectory is the best. There are of course many other ways to measure and compare the profitability and health of companies, but I think the debt trajectory tends to be the least distorted one.
The reasons why Shell is on a better trajectory than the peers I have chosen for comparison are in large part a result of its investment philosophy from the past decade or so. While Exxon and Chevron have been aggressive about accumulating shale plays, Shell famously sold one of its main Eagle Ford assets in 2014, taking a $2 billion write-down loss in the process. Given that Sanchez Energy which bought the acreage, making it its core play did, in the end, go bust, it stands to reason that Shell saved quite a bit of money by exiting the play. Instead of relying on such projects to bolster its reserves and production, Shell has been more vigilant in only pursuing potentially profitable upstream projects, in other words, projects that have a decent chance of turning a profit, given expected market conditions.
It is true that the strategy being pursued by Chevron and Exxon of expanding their shale footprint is likely to pay off this decade, as long as oil prices will go significantly higher from current levels, which I expect will be the case. It is also true, however, that in the event that another sustained period of low oil prices will occur, due to another economic shock or due to any other factors, they will be caught out and they will take far heavier losses on their upstream activities than Shell will.
Shell's strategy for a decade now has been to stop fighting the unavoidable, namely the fact that highly profitable upstream projects are a thing of the past. It is maintaining the production of oil & gas where it is feasible to do it within an assumed environment of reasonable oil & gas prices. In other words, there is a certain degree of certainty that as long as oil & gas prices do not plunge to extremely low levels as they did last year, Shell can break even or even see profits from its upstream activities. In a worst-case scenario, it will not incur losses that will be as deep as what we will see with its main peers.
Shell's green energy initiatives are arguably just as risky in terms of profitability as shale projects this decade. There is in fact an argument to be made for shale being a good investment going forward, given that the world is running out of cheap oil, therefore oil prices should in theory rise to levels that will also make shale profitable. While solar and wind power generation has been improving in terms of costs, their profitability is still highly uncertain. The same goes for EV charging stations, which Shell intends to invest heavily in.
Shell's plunge into green energy is a risk to the company's bottom line, although I do see some potential for such ventures to produce a profit. Wind & solar power generation costs have been going down. The main problem at this point is the cost of keeping the grid stable due to the intermittent nature of such power. I could see down the line a problem with electricity prices fluctuating much lower whenever there is a surplus of wind & solar production, which will affect the bottom line for all electricity producers. At the same time, certain governments are set to make sure that such investments will be profitable, which means that there is a good chance that Shell will be profitable in its green endeavors.
Shell's strengths remain its downstream operations as well as LNG
The market did not like the BG merger that was completed in early 2016. The focus on the merger was in relation to the reserves that Shell was gaining, which can be seen in the bump in reserve volumes that Shell experienced in 2016, which is visible in the chart I already cited above. It should be noted however that the merger did nothing to help with Shell's reserve life. The merger was not really about reserves, but rather about Shell's plan to become one of the most prominent actors in the LNG market. Shell currently operates about 20% of the world's LNG fleet.
As I have been stating for many years now, I see LNG as a crucial supply security and flexibility component of the overall expanding global natural gas market. Pipeline supplies may be cheaper, but there is always the danger of disruptions to supplies, as well as the lack of ability to deliver more gas when needed. Many pipelines tend to be used to full capacity in order to maximize returns on investments. Because LNG provides for supply flexibility as well as enhanced supply security, given that consumers can just contract for more or fewer supplies as needed, LNG consumption tripled between the years 2000 and 2017 according to Shell's own LNG reports. The flexibility and added supply security that LNG provides seem to make up for the less competitive pricing compared with pipeline gas. We may be coming off of a weak LNG demand period at the moment but we are seeing growing demand recently and LNG prices have been responding accordingly.
The chart above, which represents the spot price for LNG in Japan indicates that before the pandemic crisis, LNG prices were headed in the right direction from the perspective of LNG shippers. I expect that LNG will do very well this decade as more and more countries around the world are looking to secure natural gas supplies in order to reduce their dependence on dirtier-burning coal, whether out of local health considerations or due to global climate concerns. Shell is well-positioned to take advantage of this trend.
Shell's petrochemical plant near Pittsburgh is an example of its strategy in relation to the shale boom that we saw last decade. Instead of jumping in and scrambling for acreage and then producing shale oil & gas, it correctly reasoned that it can take advantage of the low natural gas price in the Appalachian region, in the aftermath of the shale boom. Even though there are signs that the boom has pretty much ended and at best, production will more or less remain flat going forward, there is still so much natural gas being supplied to the regional market that prices are likely to remain low for the rest of the decade and perhaps beyond. That may be bad news for shale gas producers, but for Shell's plant, it means that for the foreseeable future it can tap into cheap natural gas supplies as a feed for its plant.
Summing it all up, Shell is looking at an upstream sector that will shrink, not so much due to its decision to get into the whole green thing, but because it has not been able to replace its oil & gas reserves. The oil & gas that Shell will produce in the years to come will most likely be more profitable compared with its peers, most of which opted to tackle less profitable resources such as shale in order to maintain reserves and production. LNG and downstream activities are likely to be the main source of strength for Shell this decade. The green initiatives may be seen as a potential money loser by many investors, but perhaps the risk is not as acute as many might believe, given government support as well as other factors. When looking at Shell's three main sectors, as I described them, there is very little reason to expect a major deterioration in Shell's financial performance going forward. There will be damaging headlines that will elicit an emotional reaction, such as Shell's shrinking upstream production and reserves. Such headlines could play a role in dampening investor enthusiasm for Shell stock at certain points in time. In the end, however financial results should prevail, and I do think that Shell is looking somewhat better than many of its peers going forward.
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