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Outlook For Shell Mixed – Caution Ahead

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Gary Bourgeault: October 7, 2016

Summary

  • Debt load associated with BG Group acquisition still weighs heavily on Shell.
  • With a larger percentage of its business gas, it continues to struggle to sustainably break the $3 barrier.
  • EPS will probably drop by over 40 percent for the year.
  • Nigerian asset sales and risks to other holdings in the nation remain a concern.
  • Dividend could remain at current level if the price of oil and gas maintain a higher bottom.

Royal Dutch Shell plc (NYSE:RDS.A) has been taking some good steps to prepare for what it believes will be a strong future for LNG demand, as it puts various pieces of its infrastructure in place around the world. It has the goal of continuing to focus primarily on gas as its major product, looking for a time when it sustainably rebounds in price.

The long term prospects for Shell look fairly solid, but it does face some significant headwinds in the short term, including the debt overhang coming from its acquisition of BG Group, downward pressure on earnings per share (NYSEARCA:EPS), prolonged period of lower natural gas prices, and the loss of revenue from asset sales in Nigeria, along with the risk in the country for other projects it still has there.

LNG continues to struggle to gain a significant foothold, as other options with existing infrastructure are the preferred means of fuel. There is also the problem further out of what happens when it does rise and price and may not be as attractive an alternative to consumers.

The price of oil and gas have risen primarily on the proposed production cut by OPEC, which won’t have much further impact on the market as the momentum fades. If there is a real agreement put in place, it isn’t likely to do much to draw down the high global inventory levels that remain. We should see the price of oil and gas correct some time in the not too distant future, which will weigh on the earnings per share of Shell.

Shell’s debt

After the $50 billion acquisition of competitor BG Group plc, capital expenditure for 2016 is expected to come in at a little under $30 billion. By any measure in the industry, that is a very high number.

The result of this going forward is it will weaken the credit and leverage of the company, and even more so on the macro industry level, which should remain under pressure for the next 18 months at least.

Combined with low oil and gas prices, it will put pressure on the performance of Shell over the next year or two. Its major future growth engine should be LNG as a fuel source, and that is going to take time to unfold, as the company works to convince the governmental, business and consumer markets that it’s worth investing in the low price gas as a fuel source.

Shell needs the prices of oil and gas to rise in order to position itself to take advantage of its numerous assets, but its current debt load and the length of time it’s taking for the oil and gas market to rebalance, means investors will have to be patient.

I don’t see its existing dividend remaining in place if the price of oil and gas finds a decent bottom. But if its earnings continue to deteriorate if oil and gas prices correct, it would be challenging for Shell to maintain its dividend, which is at about the 7 percent range as I write. If the prices hold about where they’re at today, it’s possible the company will generate enough earnings to cover it.

Natural gas strategy

Shell is facing more of a challenge than its competitors that have oil as its major product and gas as their secondary product. Its product mix is now dominated by natural gas, and its percentage will continue to grow against oil. That obviously means supply and demand for natural gas will have more of an impact on the performance of Shell, although oil still remains a significant catalyst one way or the other.

It appears Shell sees demand for oil eventually surpassing supply in the near future, and that means it should experience some upward momentum, although the upcoming recession some time in the next few years could frustrate those expectations, with global oil demand already failing to meet prior estimates. A recession will slow down demand for oil even further, even as supply continues to remain robust.

That could cause the period of time Shell is looking for a natural gas rebound to be extended, which in turn will keep downward pressure on the share price, as it would its dividend under that scenario.

Shell has been working in some areas to build out infrastructure for LNG, but in some markets like Canada, it has had to close down some of its fueling stations because of lack of demand. It’s still waiting for the market to come to them.

I see that as a short term problem, meaning for at least a couple of years, as it takes time to build out a relatively new and for now, small market. It has to spend more on marketing and convince people it has a strong future and is cleaner than gasoline or some other fuel alternatives. LNG has to be further marketed as the transition fuel between oil and gasoline, as the world looks to have a variety of fuel and energy sources to meet its needs.

What Shell has to improve on is getting the LNG message out and better identify markets that have a strong chance to grow its LNG business.

EPS challenges

Only a significant and sustainable upward move in the prices of oil and gas will disrupt my thesis that earnings per share for Shell will probably drop by about 40 percent for 2016, and probably more than that. I look at that as the best case scenario – one that could, but is unlikely to play out.

Moving to a higher mix of natural gas has made Shell more vulnerable in regard to earnings under these market conditions, because even though gas has had its oversupply problems, natural gas has had even bigger challenges, even though it has jumped over the last several day.

Even if prices were to hold close to where they are now, paying down its debt will eat into a lot of its revenue, which will keep earnings per share under pressure. There’s nothing I see in the market that will change that outcome.

Shell will eventually reap the benefits of its natural gas strategy, but that will probably be further out than even oil as far as a market-driven rebalancing goes. That means continual pressure on earnings per share, and if prices remain lower for longer, on its dividend.

Nigerian asset sales and internal strife

With the sale of some of its Nigerian assets, Shell has lost a revenue source, and with the ongoing geopolitical challenges in the country, it provides a high-risk scenario which will have an impact on the company concerning its remaining assets there.

Things have recently taken a turn for the better, but agreements are hanging by a thread, and it would be easy for something to emerge that would cause militants to renew their attacks on infrastructure in the country.

Combined with the other challenges faced by Shell, it provides another headwind that has to be taken account of when analyzing the current and near term value of the company.

Conclusion

It is very probable Shell will get a strong return on its investment in BG Group and its decision to make natural gas its main product. For the reasons mentioned above, that isn’t going to happen anytime soon. More than likely it’ll take until 2019 – 2020 before natural gas finds sustainable support.

If a recession is in play by then, which it almost certainly will be, then rebalancing once again becomes a significant issue for both natural gas and oil. That will prolong the period of pain Shell and its peers will experience, although natural gas will continue to have a more prominent role in pricing the company.

The only thing that could change that would be a surprise on the supply and demand side, which would push up the price of oil and natural gas, which in turn would improve earnings per share beyond what it appears it is heading for during 2016, and for full year 2017.

Leverage and credit is going to be a problem now and over the next year or so, and that points to the company maintaining more of its operations as they are, than taking on any new assets. It could dilute shares and raise capital via issuing more stock, but I don’t think it will take that step for now. I see it waiting to see how long the prices of oil and gas will find support.

I wouldn’t sell Shell at this time, not until there is more visibility on the sustainability of the newly found support for oil and gas prices, and if the company will have to take steps to cut its dividend.

In the near term LNG isn’t going to have a lot of impact on the top or bottom lines of the company beyond what they are now, and that means there are stronger headwinds than tailwinds, making this an increasingly risky stock to own. If oil and gas prices find support over the next year, it could sit tight and have to do nothing to defend its dividend.

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.

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