Why Royal Dutch Shell Outperformed Expectations in Q2 2020

It’s been a horrible earnings season for most top oil and gas companies. Oil supermajors ExxonMobil, Chevron, and BP all did worse than expected in Q2 2020 as low oil prices forced drastic spending cuts and the coronavirus pandemic destroyed demand.

Bucking the trend was Royal Dutch Shell (NYSE:RDS.A)(NYSE:RDS.B), which managed to squeak out an adjusted profit of $0.16 per share, versus analysts’ expectations of a $0.31-per-share loss. As surprising as it was to see a profit — even on an adjusted basis — out of the oil industry, even Shell couldn’t pump oil profitably in Q2. Instead, it made money another way.

Here’s how CEO Ben Van Beurden and his management team strategically took advantage of unusual conditions in the energy markets to their benefit.

The raw numbers

Shell’s numbers in Q2 2020 don’t look particularly encouraging. Everything was down, down, down (except debt, which was up, up, up):

Throwing your weight around

In Texas Hold ‘Em poker, a player with a big stack of chips can use them to bully the players with small stacks, even if the player’s hand is fairly weak. Likewise, an oil company with a lot of resources can use them to outsmart the market by using tactics that smaller investors or companies can’t utilize. That’s what Shell did in Q2.

Shell’s management allowed its trading department to capitalize on some of the unique situations in the oil markets. For example, in Q2, oil futures markets were in a state of contango, which happens when the price of a futures contract for a commodity (in this case, oil) is higher than the spot price of that commodity. That’s bad for existing holders of “buy” contracts, who have essentially agreed to buy a cheap commodity at a high price. However, it’s great for an oil company, which can lock in a higher price at which to sell its oil in the future.

When a strong contango exists in the oil market, it doesn’t take a genius to take advantage of the situation. However, it certainly helps when you can pump, transport, and store your own crude oil — an advantage that most futures traders simply don’t have. It especially helps when your understanding of the industry allows you to make contango plays on non-benchmark crudes, blending components, and other nonstandard instruments. As Van Beurden said on the Q2 earnings call, “I think we do contango on steroids.”

Covert operations

However, Shell’s moves went beyond ordinary financial activities like buying and selling of futures contracts and exploiting the market’s record volatility to make arbitrage plays. Shell even adjusted its operations on the fly to take advantage of market conditions.

On the earnings call, Van Beurden offered the example of Shell’s Pernis refinery in Rotterdam. Ordinarily, it produces large amounts of jet fuel, but 90% of jet fuel market evaporated when flights began getting shut down by COVID-19.

You’d expect the company to simply lower its production of jet fuel to 10% of its usual output. Instead of incurring that expense, Shell bought cheap jet fuel on the open market — which was now awash in unused jet fuel — and used it to profitably fulfill its existing jet fuel contracts. Freed from the need to produce any jet fuel at all, the refinery could be reconfigured to make more-profitable products.

“It is a very sophisticated machinery that also works with the underlying asset base and the underlying market positions to create value that others cannot create,” said Van Beurden. “Did it work particularly well in today’s environment? Of course.”

What happens now

The volatility in the oil industry has settled down somewhat, and the oil futures market seems to have learned a hard lesson about the dangers of contango, so although Shell’s trading department will still help its performance, the benefits may not be as large in the future. On the earnings call, CFO Jessica Uhl said as much, noting that “the very strong trading and optimization performance in the second quarter is not necessarily an indication for the third quarter.”

Meanwhile, Shell is predicting that its oil production will continue to decline, to between 2.1 million and 2.4 million BOE/D, and is forecasting an average 2020 Brent crude price of $35 per barrel. It anticipates its refining margins will shrink by 30%, and expects to reduce its number of refineries from 15 to less than 10 in the coming years.

In other words, despite Shell’s outperforming expectations in Q2, the oil industry is probably still a place most investors will want to avoid.