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Royal Dutch Shell Petroleum (RDS.A: NYSE)
By Bear Stearns ($71.45, May 4, 2007)

WE HAVE UPGRADED our recommendation on Royal Dutch Shell from Underperform to Peer Perform.

We interpret Shell’s consistent operating and financial results as an indication that the company restructuring and its new management team are having a positive effect. Recovery from the reserves setbacks is underway. Management credibility has been restored, in our opinion, and the team’s focus has shifted away from reparation, to building the business through its high-quality asset portfolio.

We expect results on key performance indicators to continue to show improvement in Shell’s competitive position over the intermediate term. Our Peer Perform rating reflects modest near-term growth relative to the top-quartile performers in the peer group.

Shell’s first-quarter operating earnings were $6.6 billion, or $2.08 per American depositary share, above our estimate of $1.75 per ADS and First Call consensus of $1.66 per ADS. The most significant upside relative to our estimates occurred in the upstream business unit, though earnings were modestly above our expectations in all other business units.

We estimate Shell’s reserve replacement excluding acquisitions and divestments at approximately 121% in 2006, an improvement from an average estimated 58% in the last five years. Last year marks the first in eight years in which Shell replaced more than 100% of its production.

Oil and gas production is expected to grow at a pace of 1% to 2% per year through the end of the decade. Shell’s oil and gas production has not risen since 2002. The company’s guidance takes into account that some production in Nigeria will likely not be salvageable, following shut-ins in the Niger Delta in 2006 due to security concerns.

Shell says it currently has approximately 120 major upstream projects (projects exceeding $100 million) in the business development or design phase, and over 40 in the construction phase. Approximately 10 projects started up in 2006.
Shell A shares trade at 12.8 times earnings, and 4.9 times enterprise value to earnings before interest, taxes, depreciation, and amortization. This compares with an average 13.5 times earnings, and 5.7 times EV/EBITDA for the other large cap major oils. Historically, Shell has traded at multiples which are approximately a 0.5-point above the peer group average. Throughout 2006, Shell multiples reflected a premium based on historical relative valuations. Shell now trades at a modest discount on the same basis.

Exploration and production results were $3.4 billion, $304 million above our estimate. Results were $226 million, or 6% below a year ago, on lower production and lower price realizations. Oil and gas production was 3.46 million barrels of oil equivalent per day, below our estimate of 3.76 million barrels of oil equivalent per day, and 6% below last year. Europe gas demand was negatively impacted by warmer-than-normal weather.

Refining and marketing earnings were $1.66 billion, in line with our estimate. Results were $331 million above a year ago. Refining margins rose in all of Shell’s operating regions.

Gas and power results were $764 million, compared with $765 million in the year-ago period. Our estimate was $650 million. First-quarter liquefied natural-gas volumes rose 10% from a year ago, reflecting new volumes at Nigeria liquefied natural gas.

Chemical earnings were $480 million, $110 million above our estimates and $341 million above a year ago. A full quarter of operations at Nanhai, China, and improved margins contributed to sharply high year over year results. Plant utilization rates were 91%, even with last year.

Our 2007 earnings estimate is increased to $7.25 per ADS from $6.95 per ADS, and our cash flow estimate is increased to $11.30 from $11.00 per ADS. This reflects first-quarter results. Our 2008 earnings and cash flow estimates are unchanged at $5.60 per ADS and $9.70 per ADS, respectively.

Our 2007 and 2008 estimates reflect a price of $60 per barrel and $50 per barrel, respectively for West Texas Intermediate. We estimate that a $1-per-barrel change in oil prices impacts annual earnings by 13 cents per ADS.

— Nicole L. Decker

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