Despite the unexpected hit to the share price in January following first quarter results and a market-wide shock to equity prices, Royal Dutch Shell (RDS.A), (RDS.B) has rebounded and is making strides forward. Our analysis shows that at present a long investment opportunity exists as the business becomes more dynamic.
- Shell pride themselves on being at the forefront of technological innovation. An example of this is Prelude LNG, Shell’s floating liquefied natural gas (FLNG) facility which facilitates the production, liquefaction and storage of natural gas at sea (Royal Dutch Shell, 2018a).
- Shell is extremely well integrated along its supply chain, operating at every point from the extraction of crude oil to the distribution of refined oil products. With a strong presence in the downstream (where there is more opportunity for product differentiation), Shell is able to leverage its strong brand to boost margins.
- The dividend policy of Shell is a real asset, the company has never cut their dividends in 80 years (since 1939).
- Shell has found itself the most criticised company by NGOs, according to consultancy Sigwatch, (Moodie, 2016). This negative publicity from not-for-profits can damage corporate reputation. However, after growth of $5bn this year, Brand Finance estimates Shell’s brand value at US$37 billion, making it the world’s most valuable oil brand (Brand Finance, 2017). Following the BG acquisition in 2016, Shell has been criticised for its levels of debt. However, evidence suggests that Shell is making good headway to reduce debt through their divestment programme. Indeed, 2017 saw a reduction in net debt of $8bn and total debt by almost $7bn (Royal Dutch Shell, 2018b).
- Opportunities for Shell come in the form of increased energy demand. The U.S. Energy Information Administration estimates an increase in global consumption of 28% between 2015 and 2040, (U.S. Energy Information Administration, 2017). Furthermore, Shell estimate LNG demand to increase 4% a year globally until 2035, (Royal Dutch Shell, 2018c). Shell are well positioned to benefit as after the acquisition of the BG Group, Shell became the world’s largest trader of LNG, (Bousso, 2016). In response to increasing energy demand and changing perceptions Shell have committed to double investment in renewable technology to $2bn annually. Recent acquisitions such as a $200 million stake in Silicon Ranch corporation a US solar plant developer show their intent to pursue this (Greentech Media, 2018).
- An oil price crash is arguably the largest threat facing Shell. However, they are well suited for that eventuality. By divesting costly assets such as their oil-sands interest in Canada, CEO Van Beurden is ensuring that Shell is prepared for post-peak oil when oil prices are “lower forever”, (Royal Dutch Shell, 2017).
Net Asset Value Model
One of the key elements of our thesis is that we believe Royal Dutch Shell’s shares will increase in value based upon the company’s solid fundamentals. In order to explore this further, we have created a Net Asset Value model of Shell’s Upstream to value shell based on its current proved reserves of resources assuming they find no more reserves.
In order to create this model, we first projected Royal Dutch Shell’s daily and annual production into the future. We assumed a conservative 1% increase in production year on year as analysts’ estimates do not predict peak oil until approximately 2030, so production is likely to increase until then. It is noteworthy that Royal Dutch Shell are looking to wind down production of Bitumen, this is because both Bitumen and Synthetic crude oil are produced from the same oil sands facility in Canada and Synthetic crude oil production is more profitable. Although, as mentioned earlier, this facility is to be divested as part of the cost-cutting process.
It was then necessary to create a forecast for average realised resource prices once hedging has been accounted for. Resource prices are influenced by a number of macro and political factors and are volatile as a result. This volatility makes forecasting prices difficult and so we decided to base our estimates off of a consensus of analysts’ estimates over the medium to long-term. We found that the market seems to have priced in around $55-60 per barrel for oil and so based our profile on this information.
Integrating these profiles into the Net Asset Value model involved subtracting annual production year on year from the current reserve level. This then allowed us to estimate the number of years left in the reserves. Based on this estimate Shell has 11 years left of natural gas, 8 years of oil and 22 years of synthetic crude.
By multiplying the projected annual production figures by the projected average realised price of resources we can estimate revenues for the future. Subtracting extrapolated production and development expenses produces Pre – Tax cash flows. These figures can then be taxed and discounted with a WACC of 7% to produce an estimated enterprise value of Royal Dutch Shell’s upstream of $148bn.
Valuing Royal Dutch Shell’s downstream activities based on net assets was not possible, so we chose to evaluate the health of the downstream qualitatively. Downstream forms the bulk of Royal Dutch Shell’s revenue and is split into two different product classes, oil products and chemicals.
An increase in earnings from $6.6bn in 2016 to $8.2bn in 2017 (Royal Dutch Shell, 2018b) has been primarily driven by increasing global resource prices, the previous fall in which explains the earnings slump from 2015 to 2016. In addition to this, driven by recent low resource prices, Shell has begun cutting costs in production and across the business. Since 2015, Shell has cut their operating expense in downstream by 6% showing that they are proactively responding to the low resource price environment with efficiency improvements (Royal Dutch Shell, 2018b).
It is also important to note that oil product sales volumes have increased by 6% over 2 years and chemicals sales volumes have steadily increased as well (Royal Dutch Shell, 2018b). This is indicative of the health of the downstream business, which coupled with the strength of the upstream business, leads us to believe that Royal Dutch Shell is valued appropriately for investors to take up a long position.
Recommendation - Buy
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Greentech Media, 2018. Shell Takes a Major Stake in US Solar Developer Silicon Ranch. [online] Greentechmedia.com. Available from: Shell Takes a Major Stake in US Solar Developer Silicon Ranch [Accessed 27 Apr. 2018].
Moodie, A., 2016. The world’s most hated company: can NGOs help turn around Shell’s reputation?. [online] the Guardian. Available from: The world's most hated company: can NGOs help turn around Shell's reputation? [Accessed 27 Apr. 2018].
Royal Dutch Shell, 2017. Shell completes divestment of oil sands interests in Canada. [online] Shell.com. Available from: Shell completes divestment of oil sands interests in Canada [Accessed 27 Apr. 2018].
Royal Dutch Shell, 2018a. Floating LNG. [online] Shell.com. Available from: Floating LNG [Accessed 27 Apr. 2018].
Royal Dutch Shell, 2018b. Shell Annual Report 2017. [Online] Available at: https://www.shell.com/investors/financialreporting/annualpublications.html#iframe=L3JlcG9ydC1ob21lLzIwMTcv[Accessed 19 03 2018].
Royal Dutch Shell, 2018c. Shell launches LNG Outlook 2018. [online] Shell.com. Available from: Shell launches LNG Outlook 2018 [Accessed 27 Apr. 2018].
U.S. Energy Information Administration, 2017. [online] Eia.gov. Available from: EIA projects 28% increase in world energy use by 2040 - Today in Energy - U.S. Energy Information Administration (EIA) [Accessed 27 Apr. 2018].
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.
Additional disclosure: Uploaded on behalf of Team Griffin, Students of Bath Investment Club.