January 2008 – Analysis – The report card

PetroleumEconomist.com

Shell: time to deliver

With a healthy inventory of upstream projects in development, Shell must put its operational mettle to the test. Tom Nicholls writes

GOOD things come to those who wait. No pain, no gain. Every cloud has a silver lining. For investors in Royal Dutch Shell in need of a pep talk, these might be clichés worth repeating.

Since 2004 – when it was forced to make large reductions to its proved oil and gas reserves, after admitting to having grossly exaggerated them – Shell has been trying to invest its way out of trouble. On paper, the policy looks set to pay off: work in progress includes several liquefied natural gas (LNG) projects – Pluto, Browse and Gorgon in Australia, Sakhalin in Russia, Qatargas 4 and ventures in Nigeria (see p28); various field developments, including Norway’s Ormen Lange gasfield, Nigeria’s Bonga and Kazakhstan’s Kashagan oilfields; the pioneering Pearl gas-to-liquids (GTL) project in Qatar; and a large gas-oriented exploration venture in Libya.

No quick returns

The snag is – certainly for investors looking for a quick return – projects of this size take years to develop, soak up billions of dollars in capital and involve significant execution risk; with the contracting market at full stretch, cost over-runs and project delays have become a familiar phenomenon, as Shell’s investors are only too aware.

Projected spending at the Sakhalin LNG scheme doubled from the original budget of $10bn, hastening the loss of Shell’s majority stake in the project to Gazprom in late 2006. Shell is also part of the investment group developing the Eni-operated Kashagan field: the consortium seems likely to have to pay either a cash penalty or cede a bigger state stake in the project to state-owned entities as compensation for missed deadlines and overspending.

But for investors taking a long-term view, Shell offers potential for considerable growth: the silver lining to the cloud of the reserves-misreporting scandal is that it made the company invest more upstream than it would have otherwise done, says Peter Hitchens, an analyst at Seymour Pierce, a stockbroker. While some oil companies have tried, in recent years, to generate value for shareholders by buying back their own stock, Shell – making relatively bullish assumptions about oil prices – has put greater faith in organic growth. “Shell had to dig itself out of a hole and has been more pro-active than a lot of integrated oil companies in that it has realised its failings,” says Hitchens.

There is a chance – however remote – that growth might come inorganically, says ABN Amro, describing a merger with BP or Total as “possible and desirable”. However, the likelihood is that it will be success with the drillbit that determines whether it reaches its production targets of 3.9m barrels of oil equivalent a day (boe/d) by 2009 and 4.5m boe/d by 2015, from the present level of 3.5m-3.6m boe/d (see box). At the same time, it must ensure the large ventures in development – operatorships include the Athabasca Oil Sands Project (AOSP), Pearl GTL, Ormen Lange, Sakhalin Energy and Bonga – come to fruition at a minimum of fuss and cost.

At the same time, it must keep its producing operations ticking over elsewhere. Nigeria continues to present the company with severe difficulties: violence in the Niger Delta has caused significant production shut-ins since February 2006 and half of the onshore capacity of 0.95m barrels a day (b/d) that the group controls remains unavailable.

Encouragingly, Shell’s investment drive is having results. Last year, it consolidated its position in Canada’s unconventional-oil sector, fully absorbing Shell Canada. Its 60% owned AOSP promises considerable reserves and production growth, which should help offset the loss of equity in Sakhalin Energy. The project produces 155,000 boe/d and production could eventually reach 0.5m boe/d. Shell’s old rival, BP, has only just entered the oil sands (see p26).

Powerful gas position

It has also established a powerful position in world gas trade, through a series of large investments in gas-liquefaction, regasification and shipping capacity. And in parallel with South Africa’s Sasol and the US’ Chevron, it is leading the development of the GTL industry. Pearl GTL will produce 140,000 b/d of GTL products and 120,000 boe/d of condensate, liquefied petroleum gas and ethane. The company says it will spend a hefty $12bn-18bn on the project, but, given the present level of oil prices, that investment should pay off. According to Wood Mackenzie, with oil prices at $65 a barrel and assuming capex of $18bn, Pearl’s pre-tax internal rate of return should comfortably exceed 20%. However, although spending on the project may end up as high as $20bn, oil prices are around 35% above the $65/b benchmark.

Pearl will fit comfortably into Shell’s downstream division. The firm has 40 refineries worldwide and, it claims, the world’s largest retail network, with 45,000 service stations in more than 90 countries. Its chemicals segment contributed just over 5% of earnings in the third quarter. It is investing in emerging energy technologies, such as coal gasification and carbon capture and storage, and is dabbling in renewables (although it has just sold some solar assets in Sri Lanka and India). However, exploration and production (E&P) remains dominant, as its motto – “more upstream, profitable downstream” – attests.

In the third quarter, over half of its earnings of $6.392bn (on a current cost of supplies basis) were generated from upstream activity. The next largest contribution came from the oil-products division – downstream businesses – with about a quarter. Going forward, the emphasis is firmly on E&P: around 80% of its $22bn-23bn capital spending budget for 2007 – up from $21bn in 2006 – was allocated to upstream projects.

Reserves recovery

Analysts claim Shell is capable of transforming that investment into a much improved upstream – and financial – performance in the years to come. ABN Amro says the company’s reserves-replacement ratio should recover to 100% between 2007 and 2011, from the paltry 60% recorded in 2001-2005, with the 157% rate for 2006 (including oil sands) providing a strong start to the recovery. Deutsche Bank, in an end-November research note, said Shell has now put the 2004 scandal behind it. “For the first time since the reserves debacle, Shell feels like a business in control of its own destiny.”

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