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Royal Dutch Shell: Energy Transition Woes

Royal Dutch Shell: Energy Transition Woes

Summary
  • Poor messaging from management, as well as an ill-prepared balance sheet caused in part by buybacks, has caused the European major a lot of pain.
  • Arguably, senior executives deserve to be shown the door. But even if that happens, expect the pivot away from fossil fuels to continue.
  • Is the move into Power and other “Green Energy” assets the right move? Maybe, maybe not.
  • This idea was discussed in more depth with members of my private investing community, Energy Income Authority. Get started today »

I often get asked why I don’t cover the supermajors all that often on Seeking Alpha. The answer comes down to a rather simple reality: time invested versus potential gain. Anyone that has followed my long / short book knows that whatever I take a stake in, I know inside out. Quite frankly, the sprawling operations of most majors coupled with competing against institutionals that have enough research analysts on the payroll to pack a local gymnasium makes it a losing proposition – or at least in my view.

Nonetheless, I do have loose preferences among the majors and I do follow them all, if only to have a pulse on the global industry. There is no better barometer for the energy sector at large than this group. Royal Dutch Shell (RDS.A)(RDS.B) has gotten quite a bit of press lately, in large part due to the dividend cut but also the path senior executives are taking the company down. There is a bit of misunderstanding on this in my view, and I think it is worth talking about the strategy and whether it has merit.

The “Energy Transition”

Shareholders are deeply skeptical of the path CEO Ben Van Beurden has taken the company over recent years. Yes, years, because investors can trace the roots of this move back quite some time. Investors can be forgiven for that, and I think they tend to misunderstand the pivot European energy firms like Shell are undertaking. That largely stems from executives trying to avoid conflict and just plain old poor communication; both of which should not be forgiven.

For those that felt the rig was pulled out form under them, the optics on the dividend cut were poor, but was to a large degree inevitable given current strip prices. My own rough models – and current Wall Street consensus – would have had Shell running cash flow deficits through the end of 2022 if the old payout was left intact. Anyone that forecast current pricing prior to the cut – or just used it as a stress testing tool many quarters ago – should have been running for the hills. No sane Board of Directors, especially one like this which has prioritized deleveraging and having capital access to fund a foundational business change, would leave the current payout intact.

Unfortunately, Shell found itself in a vulnerable position trying to keep two separate investor classes happy: traditional buyers that owned the company for its cash generative fossil fuel assets and newer institutionals with no interest in a carbon business. The coronavirus has accelerated a shift in tone, but Shell has long been on this path. Like it or not, being based out of Europe where these issues are even more divisive has only widened the gap between the two. Here on Seeking Alpha, most tend to fall in the former group, with grievances that inevitably fall within a few categories:

  1. Investing heavily in green energy projects which have historically unproven returns instead of focusing of boosting oil and gas reserves is value destructive.
  2. Investing in green energy in the first place. This is a fossil fuel company – not a renewables firm. As such, there is no competitive advantage.
  3. Poor choices (buybacks, BG Group timing, messaging on dividend) have destroyed shareholder capital. Shareholders should not buy what this company is selling.

Investors would be forgiven for writing the company off because of the last item, but remember that sometimes dividend cuts can represent peak pessimism. As an example, Kinder Morgan (KMI) has staunchly outperformed its large cap peers like Enterprise Product Partners (EPD), Magellan Midstream (MMP), and others since the fateful “Kindering” late in 2015. Rather than lamenting the past, instead I think it worthwhile to talk about the strategy here. For anyone that thinks management can learn from its past mistakes or might simply just fire Van Beurden as a sacrificial lamb while keeping its trajectory, it pays to understand the direction the company is heading and evaluate it independently.

Upstream

As far as actual drilling is concerned, the focus is going to be on managing existing assets – not expansion. This runs counter to other large corporations, such as Chevron (CVX) which is picking up Noble Energy (NBL) for a song. Today, Shell generates the vast majority of its earnings in this segment from just a few key areas globally, such as Oman, the US Gulf of Mexico, Australia, and Canada. These assets are characterized by great resource depth, sizeable infrastructure, and low breakevens. In my view, the company has actually done a great job of high-grading its assets across the entirety of its business but especially in Upstream, selling significant land and mineral interest holdings post BG Group transaction (roughly $18B worth company-wide). Shell’s presence globally has been simplified as a result, and I think investors have focused far too much on the flatlining in proved/probable reserves without considering the impact of these divestitures and the resource quality that remains.

Within these core areas, there is plenty of opportunity for brownfield development, using tie-backs and targeted drilling to prop up annual production with minimal investment. This is a margin-based mindset; something that the oil and gas industry did not emphasize as much as it should in the past decade. Looking forward, I see Shell averaging between 3,200 – 3,300 kboepd through 2023, pretty flat results compared to 2020 but with improving oil mix and lower costs as projects like those in the Permian and Troll Phase 3 in the North Sea come online. Importantly, breakevens are set to continue to come down and Shell will be able to maintain production levels with lower amounts of capex dollars compared to the 2016 – 2019 timeframe. That is a big win.

Problems In Power, Case For Biodiesel

Earnings results in Power, what Shell views a potential long-running transition for the firm, have been a topic of much contention. Nearly all of its European rivals (Total (TOT), BP (BP), others) are stepping into the power business, an area traditionally dominated by long-standing utilities earning very low rates of return. Of the European majors, Shell has the biggest plans for spending in the new division, aiming to invest tens of billions of dollars over the course of the decade. It has already spent considerable sums acquiring various businesses like First Utility and Sonnen and is spending substantial money developing other assets organically, like Delga Solar in Australia and Borssele III / IV (offshore wind) in the Netherlands.

To date, these investments are not generating positive cash flow – symptomatic of a lack of scale and an infrastructure buildout. This is likely to persist for years, particularly as management has stated often that they want to build this business organically versus making a large acquisition. While many view this as Shell stepping outside of its comfort zone, remember that renewable power is also a nascent business for nearly everyone. Establishing a core competency in this decade would position it well for the next, and there is some overlap in the business via its marketing and trading arms as these are predominantly not rate-regulated power businesses.

There is some merit to this move. The expectation is that as subsidies for both wind and solar ease and the technology becomes more ubiquitous, renewables will increasingly become a merchant power business. In other words, the electricity market will be filled with competitors operating in competitive markets with no long term power purchase agreements (“PPAs”). Without an established platform base and years of work on integration, it would be far more expensive and painful for shareholders to bear the transition then versus now.

Management is playing a (very) long game, but renewables will inevitably increase in importance in the coming years. That is something that I think (nearly) all investors in energy should agree on. The question is the timing and severity of the shift, as well as the relative value proposition of legacy assets versus new age technologies today. Retail investors often lament Wall Street for focusing too much on near-term earnings results, but are doing the same thing here: punishing Shell for trying to position itself for success in the 2030’s and beyond. Rather than lamenting the firm trying to get a foothold in emerging technologies, I believe investors should hold management to task on their outlook and targeted returns in the space – including pushing to tie senior executive compensation to results in this segment.

It isn’t only power projects that Shell is pursuing that are not fossil fuel centric. Many on the side of green energy have lamented how dirty for the environment many products can be, particularly lithium ion (batteries) or solar panels (cadmium, lead leeching). Hydrogen by comparison is quite clean, and Shell has decades of experience with the product. It is advancing hydrotreated vegetable oil (“HVO”) plant conversions or new developments as well, once again a great way to leverage its existing downstream infrastructure to a product seeing great growth. While both currently do not find their way onto management lists of products that will see final investment decision (“FID”) in the short term, I expect to see announcements down the line. Liquefied natural gas (“LNG”) projects are also going to continue to see significant appetite, current drop in demand for the product notwithstanding.

Takeaways

Renewables / “green energy” will have their place in the coming energy landscape. Even on an unsubsidized basis, they are breakeven (or better) on a cost per megawatt hour in many locales when used as an intermittent power source. While there are significant challenges and many on the greener side of things have pushed the transition beyond what is prudent for the populace (see California), technology is improving every day.

As I’ve advocated often, investors should not define themselves in a black and white way. Being “anti renewable” or “anti fossil fuels” is a recipe for weak returns in a very tough space. Instead, investors should allocate capital where they have the best probability of earning positive risk-adjusted returns. While perhaps a bit bluntly capitalistic, I believe most in the market should invest to make money, not take a stance on a divisive issue. When taking that approach, reality is much more gray, with winners and losers on both sides.

Given that, it is worth keeping an open mind on the Royal Dutch Shell strategy. To me, the pivot alone is not a reason to sell. Lost faith in management? Always a great reason to cut. Firm not earning its cost of capital or generating forecast returns? Also a good reason to stay away. Facets like this can and will change with time. Long story short, buy or sell for the right reasons.

SOURCE

royaldutchshellplc.com and its sister websites royaldutchshellgroup.com, shellenergy.website, shellnazihistory.com, royaldutchshell.website, johndonovan.website, shellnews.net and shell2004.com are all owned by John Donovan. There is also a Wikipedia article.

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