Shell: The Best Big Oil Stock for Investors (BARRONS) (1/2)
Royal Dutch Shell’s makeover could lift the shares more than 20% in a year—even without a rise in oil prices. Plus, a juicy 6.6% yield.
By Jack Hough
July 16, 2016
CEO Ben van Beurden plans to fund growth in areas where Shell has a competitive advantage. Photo: Chris Bolin/Polaris/Shel
A dash of desperation is working wonders for Royal Dutch Shell. The price of Brent crude oil has fallen by half in two years, pulling Shell’s cash flow from operations well below what it typically needs to pay its dividend and fund exploration. Meanwhile, the purchase of United Kingdom gas specialist BG Group, completed in February, left Shell with a full tank of debt.
Something had to give. Investors braced for a dividend cut, which is why the American depositary receipts (ticker: RDS.B) started the year priced low enough to yield 8%. But rather than reduce its payout, Shell slashed spending on projects and sold low-return businesses. Last month, it announced a capital plan through 2020 that calls for more asset sales and a limit on capital spending.
The shares are up 24% year to date. Maybe that’s because crude has moved up 28% over the same period. And maybe investors are gaining a bit of confidence in the dividend, although the yield, at 6.6%, is double what ExxonMobil (XOM) pays.
Whatever the reasons, Shell, recently $57.01, could top $70 in a year, for a total return of about 30%. Indeed, the dividend looks affordable through the end of the decade and beyond, even with a lower oil price. And with crude production falling, the price might push higher in coming years. More important, Shell’s new plan looks like more than just an austerity drive. It looks like a recommitment to capitalism.
The industry goes through a financial reckoning from time to time. When oil prices are high, Big Oil reports hefty profits from existing production. You’d think it would then reinvest capital at attractive rates of return. Instead, the supermajors spend lavishly to buy up and drill into anything that smells like reserve replacements, while competing against upstarts and newly ambitious state-owned oil companies for scarce resources. The result is a dwindling return on capital employed, which the market ultimately punishes with a lower stock valuation.
Investors tend to think of energy stocks as something to buy when low oil and gas prices look ready to rebound. An even better approach might be to buy them when market conditions have battered them into embracing better capital discipline.
Doug Terreson, a top-rated energy analyst at Evercore ISI, has made a study of the matter. Over the past decade, the five supermajors—Exxon, Shell, BP (BP), Total (TOT), and Chevron (CVX)—spent $1.2 trillion on capital investments, nearly triple what they spent during the prior decade. Return on capital employed plunged by more than two-thirds in 2015 from its 2005 level, even though the prices companies realized on their oil and gas sales, after hedging, were similar.
What was different in 2005? A severe drop in the price of crude in 1997 and 1998 forced the industry into a long period of restrained spending and investment that drove capital returns higher. Investors made out well. Exxon’s stock price doubled from the end of 1996 to 2005. By then, the supermajors traded at an average of 2.8 times the book value of their assets. Then an oil-price spike paved the way to a decade of mostly high prices, aside from the recent downturn and a sharp but short drop in 2008. Big Oil got sloppy with its spending. Returns suffered, and valuations fell to 1.4 times book value.
“Every one of the majors would say they underestimated investment risk,” says Terreson. “A lot of projects came in both late and over budget. They were trying much harder to become larger than they were to become more valuable.”
Shell’s new commitment to prioritize returns over growth, which it says it will stick with in coming years even if crude rises, could mark a fresh turn in the cycle. The other supermajors have brought down their capital spending, too. Shell stock has run ahead of the group this year, and could continue to do so, because the company carries more debt than its peers—and so is priced more pessimistically by investors—and because the BG deal adds attractive assets and plenty of room to cut operating costs. But the entire group looks priced to beat the market in coming years.
SHELL TRANSPORT AND TRADING, originally called the Tank Syndicate, began to carry oil in 1892 from Central Asia west using a new shipboard storage method: bulk tanks rather than barrels. The father of its two founding brothers was a London shopkeeper who imported shells for decor, hence the name. Royal Dutch Petroleum traces its roots to a Sumatra drilling operation started in 1890. The two merged in 1907 to better compete with the might of Standard Oil. (Four years later, Standard was broken up under the Sherman Antitrust Act into dozens of companies, two of which would later become Exxon and Mobil.)
Royal Dutch and Shell operated jointly but maintained separate corporate identities in the Hague and London, respectively, and a 60/40 ownership split for nearly a century. The complex structure made the group slow to act during a merger spree set off by the 1998 oil slump. Exxon merged with Mobil, BP bought Amoco and Arco, Total scooped up PetroFina and Elf Aquitaine, and Chevron grabbed Texaco.
Acquisitions are an easy way for energy companies to add new reserves to tout on Wall Street. But an easier way still is to make them up. An accounting scandal led Royal Dutch Shell to take down its reserves by 20% in 2004. Under pressure from investors to simplify oversight, new management combined boards and stock listings. Today Royal Dutch Shell, commonly called Shell, is based in the Netherlands but incorporated in the United Kingdom, with a primary stock listing in London and secondary ones in Amsterdam and New York.