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Shell Replaced Only 26% Of Its Produced Reserves In 2014

Screen Shot 2015-02-24 at 11.00.06From an article by Zoltan Ban published 23 Feb 2015 by Seeking Alpha under the headline:

Shell Replaced Only 26% Of Its Produced Reserves In 2014

Summary

  • Shell replaced only 26% of its produced reserves in 2014.

  • The three year average rate of reserve replacement is 67%.

  • Even with potential for growth in the downstream, Shell is likely to undergo a continued process of shrinkage as a company in the longer term.

Royal Dutch Shell (RDS.A, RDS.B) produced 1.2 billion barrels of oil equivalent in 2014. Only 26% of that was replaced with new reserves, which means that just over 300 million barrels of oil equivalent were added. Over the past three years, 67% reserve replacement was achieved, which looks much better, but still suggests that Shell is a shrinking upstream producer (link).

Shrinking oil production has already been a well-established trend with this company since 2010, but the current low reserve replacement ratio suggests that there is much worse to come.

Screen Shot 2015-02-24 at 10.52.36

Data source: RDS.

Aside from the fact that reserves are declining, the quality of those reserves is very different compared to reserves already on the books. Increasingly, we are looking at unconventional reserves such as shale oil & gas, as well as deep water fields that are very expensive to develop. Enhanced recovery from old fields also features prominently in the company’s reserve replacement strategy.

We should keep in mind that these reserve additions were achieved during a year when the second half saw a constant slide in prices, therefore we should be mindful of the fact that the rate of reserve replacement should improve if the price of oil will recover to the $100/barrel range we experienced in the past half a decade or so. The 2014 reserve replacement rate is in part a reflection of lower oil prices in the second half of the year. Shell data shows us that even in the preceding years, it failed to replace 100% of the reserves produced. If prices will stay well bellow $100 for the foreseeable future, it is very likely that reserve addition will suffer a similar fate to 2014, this year and most likely next year as well.

This trend of shrinking reserves should have been foreseen as Shell struggled to make a number of frontier projects happen. It sold its Catarina play in the Eagle Ford to Sanchez Energy (NYSE:SN) last year, admitting that it was unprofitable. It gave up on trying to produce oil out of Kerogen and it also put its arctic drilling program in Alaska on hold. Given the relative difficulty faced by many multinational oil & gas companies in trying to tap new conventional reserves, it would have been very good news for Shell if some of the unconventional or frontier plays would have worked out.

Production decline rate to mirror decline in reserves.

As we can see from the above graph, there is already a well-established production decline trend in place for some years now. The rate of decline will in fact start to accelerate as the reserve base Shell is basing its production on declines as well. Given that in the next few years and for the foreseeable future oil & gas prices will likely be volatile and on average significantly lower than the $100 oil price plateau we saw in the past four years, reserve additions will also be significantly lower than in past years.

It is hard to predict what the exact extent of this decline in reserves and therefore production will look like, but given that Shell only managed to replace about two thirds of the reserves it produced in the past three years, I think it is also reasonable to expect that production will be about a third lower a decade from now. The current reserves of 13.1 billion barrels of oil equivalent are only enough to last for about a decade, therefore a decade from now, production will in theory more or less reflect the current and future reserve addition volumes. The picture will worsen significantly if future rate of reserve replacement will become more like what we saw in 2014.

Future revenue potentially hit by lower production and possibly lower prices. Downstream may be bright spot.

With lower oil & gas production, revenues have also been taking a hit in the past few years. After hitting a record of $484 billion in 2011, it has been sliding steadily for three years in a row and we already know that 2015 will be a terrible year given oil prices.

Screen Shot 2015-02-24 at 10.53.34

Data source: RDS.

As we can see, even in the 2012-14 period, revenues were down, year after year, even though the price of oil remained on the $100 plateau for most of that time. Now with production in decline and the price of oil likely to be more volatile and generally lower on average than the $100 level which companies started to take for granted, it is probable that Shell will never manage to surpass the revenue level it achieved in 2011.

There is increasing evidence that Shell is in a permanent state of shrinkage and what is worse, it seems that its debt level, while very manageable at the moment, given the size of the company, is on an increasing path in the past few years and given the current oil price environment, this year and possibly next year as well will not only show a continuation of the trend but also an acceleration.

Screen Shot 2015-02-24 at 10.54.21

Source: RDS.

The downstream segment.

If there is a potential bright spot out there for Shell in the long-term, it has to be the downstream segment. 2014 cash flow from downstream operations increased by 40% compared to previous year, while upstream cash flow increased 6%. The upstream segment is still by far the most important part of the company’s operations, with earnings from upstream being almost three times larger than downstream, but there is definitely more potential in value-added operations.

Shell’s massive cracker plant near Pittsburgh, which is in its early planning stages, with land recently having been purchased to build the plant on, is an example of the kinds of opportunities for value added investments. Shale gas in the region sells for very cheap compared to the US spot price due to supply outgrowing regional demand. Making use of production from the Marcellus & Utica shale gas fields makes far more sense than trying to simply sell the gas into an over-saturated regional market.

I expect that Shell will continue to pursue such projects around the world and I do believe that it will serve to partly offset the decline in oil & gas production the company is likely to continue to experience in the foreseeable future.

Even with such downstream investments, Shell will not be able to prevent its continued shrinkage as a company. This is likely to be the fate of many other similar oil & gas giants as challenges such as declining discoveries, increased resource nationalism and failures to tap new frontiers will take their toll. While Shell does provide for a good investment opportunity for those looking to get a good dividend, and take advantage of oil prices rebounding this year or next, its long-term potential is not looking very bright.

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