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MONEY – INVESTING: High oil price offsets reserve fears

Financial Times: MONEY – INVESTING: High oil price offsets reserve fears

7 May 2005

By James Boxell

Given its travails over the past year and a half, it is surprising that Royal Dutch/Shell has so many fans in the investment community.

The company was forced to cut its level of proven oil and gas reserves, a key measure of an energy group’s underlying health, by a third last year. This led to the acrimonious departure of its three most senior executives, $150m of fines from US and UK stock market regulators and several class action lawsuits.

Shell replaced just one in five of the barrels of oil and gas that it extracted and sold last year, another sign of how poorly the company is doing relative to its peers.

While the world’s five biggest listed oil companies – ExxonMobil, BP, Shell, Total and ChevronTexaco – have on average enough oil and gas to last them for the next 12 years, Shell’s reserve life on its own is down to about nine years.

Yet Shell’s shares have outperformed those of BP, its better-run rival, by 8 per cent over the past year.

Richard Rose, oil analyst at Oriel Securities who has a hold recommendation, says much of this is attributable to crude oil prices of about $50 a barrel. “Shell is living on the macro fundamentals rather than what it is doing near-term on reserves and production,” he says.

This was reflected in record profits of $5.55bn for the first three months of 2005, marginally ahead of those at BP. Despite BP’s much stronger position on reserve replacement and production, Shell is reaping a bigger windfall through the high crude price because of the pre-eminence of its downstream business.

Mark Iannotti, analyst at Merrill Lynch, describes Shell as “the outstanding refining and marketing company in the industry. It shone out against BP and Exxon in the first quarter.”

Shell is making excellent margins from its refining business because it can buy in cheaper, heavy crude oils and refine them into expensive, higher quality products.

Analysts also cite technical issues related to the forthcoming merger of Shell’s Dutch and British holding companies as a reason to buy the stock, at least in the short term. The merger will create a behemoth accounting for 9 per cent of the FTSE 100, and tracker funds and big institutional funds will need to reflect this. The merger is expected to be finalised in July and analysts believe the drive to buy Shell stock will inflate its shares for at least the next few months.

Merrill Lynch believes that in the short term, given the possible upside on refining, Shell looks cheap relative to its peers, Exxon and BP. It trades on an enterprise value to debt-adjusted cashflow multiple for 2006 of 7.3 times, compared with 8.6 times at BP and a whopping 11.1 times at Exxon. Its dividend yield also compares favourably.

But while the short-term rationale appears compelling, the longer view is more murky. Merrill Lynch harbours reservations on “re-investment quality, strategic direction and management vision”. Shell’s production of oil and gas has fallen and is expected to be stagnant at best for the next few years, while BP is growing.

As Iannotti puts it: “Short term, Shell is a more interesting stock, but BP is the superior company.”

There is also the risk that Shell might be encouraged to buy its way out of trouble because of its extremely low gearing, but at a time when high oil prices make deals difficult to justify.

Jonathan Copus, analyst at Investec, who previously worked at Shell, says there is some truth in claims from the company that its underlying resource base of 60bn barrels of oil and gas has not changed even though it was forced to unbook a big chunk of reserves as not yet commercial.

He says “legacy projects” in countries such as Kazakhastan, Nigeria, Russia and Qatar will come on line in the next few years and that many of these fields will offer lower decline rates than some of BP’s.

He also points to the strength of Shell’s position in liquefied natural gas, one of the energy sector’s biggest growth markets, and unconventional oil, such as the heavy oil extracted from sand in Canada.

Merrill Lynch says that Shell is making a big push to refill its depleted reserve base, but this might be at the expense of profitability. It appears that BP is better positioned because its projects in the deep waters of the Gulf of Mexico and Angola offer far greater rates of return.

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