Shell’s Strategy Is Satisfactory

The purpose of this article is to analyze Shell’s recent and very important Strategy Day. Shell had promised to give a lot of detail on an organizational restructuring at this event and it had the potential to radically change Shell’s direction. This means the Strategy Day presentations had a possibility to change my bullish thesis on the company. In that article I also gave some of my expectations of what I expected to see in Shell’s Strategy Day, and here I review the key takeaways of the Strategy Day and what they mean for my bullish thesis.

I also compare Shell to its long-time closest supermajor rival and FTSE 100 peer BP plc (BP), as it was BP that was the first supermajor to present to investors, a year ago, a decision to radically overhaul strategy and organizational structure to prepare for the energy transition and target “net zero” carbon emissions in line with the Paris Agreement. American supermajor peers Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) are not mentioned as to date they have not indicated any major structural changes to their business models. However, this article may still be of interest to shareholders of Exxon Mobil and Chevron as it is likely they will soon be forced by institutional investors to choose between two options on strategy. One, staying the course like Shell as we shall see below. Or two, following BP’s lead in transforming away from an integrated oil company with an emphasis on hydrocarbons to an integrated energy company with an emphasis on growth in renewable power and moving more downstream in the energy value chain.

Shell’s Strategy Summary

Royal Dutch Shell plc (OTCPK:RYDAF) (NYSE:RDS.A) (NYSE:RDS.B) said in its Strategy Day 2021 that it aims be a net-zero emissions energy business by 2050. That will be on Scope 3 levels meaning its own production, emissions from its own operations and emissions from the customers who buy its products. To help achieve this goal it will stop selling to customers who do not have their own carbon reduction targets.

The oil and gas supermajor said that its oil production peaked in 2019 and that going forward it should decrease by about 1%-2% per year. Shell also noted its overall carbon emissions peaked in 2018 at 1.7 gigatonnes.

By 2035 Shell will aim to remove and store 25 million tonnes worth of emissions through carbon capture and storage. Currently, it has capacity of 4.5 million tonnes of carbon capture and storage. If it can’t eliminate or reduce emissions it will offset them with nature-based solutions. Nature based solutions are a bit like paying a fine for bad behavior: financially painful for Shell, but it does not really help the world overall, since the nature was already there (or potentially there) for offsetting carbon, basically nature’s natural carbon sinks become financial assets which can be used to account for a certain level of carbon emissions. It is hardly innovative. BP had previously said they will use nature-based solutions but won’t rely on them. Anyway, Shell expects to use 120 million tonnes per year of nature-based solutions by 2030. That is a lot of trees.

On a more positive note, Shell will allocate carbon budgets to its various divisions and work with various industries such as aviation and shipping to help them engineer down their emissions.

Beginning with its 2021 annual general meeting, Shell will give shareholders an advisory vote on its transition plan. This will be very interesting because we will see if institutional investors really want to invest in an energy conglomerate diversifying rapidly in new business areas or would just prefer a focused business generating returns from traditional integrated oil and gas assets.

On capital expenditure Shell guided investing $19 billion to $22 billion each year with $5 billion to $6 billion for growth areas (a fifty-fifty split between marketing and renewable energy), another $8 billion for Upstream (oil exploration and production), and $8 billion to $9 billion for transition businesses (fifty-fifty natural gas and chemicals).

The group is targeting a reduction of carbon intensity, meaning emissions per unit of energy produced, by 6% to 8% on 2016 levels by 2023. This target increases to 20% for 2030, 45% for 2035 and 100% for 2050.

Analysis

With 11 billion people estimated to live on planet Earth by the end of the century, there is no doubt we need growing amounts of energy. The question is just which energies and how?

Shell’s strategy does not appear to be as aggressive as BP’s, giving investors a clearer choice between BP and Shell. With BP you get a faster transition away from oil and gas into low carbon energy and what looks like a bigger focus on customers and retail. With Shell you get a core of oil and gas (Upstream, Integrated Gas, Chemicals and Products) taking 70-80% of near-term capex, with Marketing and a brand-new division called Renewable and Energy Solutions getting about 25% of near-term capex. The “Transition” segment (Integrated Gas, Chemicals and Products) is expected to produce about 45% of Shell’s cash flow from operations when net debt is above the target of $65 billion and still about 45% after 2025, making it Shell’s biggest division. Again, this shows that Shell, without a major divestment (which it has not indicated), is somewhat hostage to the 2016 acquisition of BG, which essentially cemented the Integrated Gas division as the core of Shell, but that’s OK, as I will explain in a moment. This emphasis on the Integrated Gas division was somewhat expected as I mentioned in my recent Seeking Alpha article Don’t Sell Shell.

So whereas BP is dividing itself into Oil (where it plans to cut production by 40% by 2030), Customers & products (essentially a greater focus on higher margin retail and convenience stores) and Gas & low carbon energy (where it will ramp up quickly renewable energy), Shell is dividing itself into Upstream (legacy exploration and production which at 1-2% decline is hardly transformational), Transition (essentially natural gas and refining, which is still a hydrocarbon set of businesses) and Growth (marketing, renewables and energy solutions, essentially its customer facing business). Ultimately BP boss Bernard Looney is going practically all in, while Shell boss Ben van Beurden is being very much more cautious.

The Global Investor thinks Looney might have read The Innovator’s Dilemma by Clayton Christensen and decided renewable energy might be the new technology that could make a great firm like BP fail if it does not act fast to change its position utilizing internal and external knowhow. After all, Looney has a master’s degree in management from the Stanford Graduate School of Business. Maybe that is dangerous?

Mr van Beurden, who has a master’s degree in Chemical Engineering, looks like he has read Focus by Al Ries. In this book, Ries goes over many examples where companies who try to diversify and get away from their core competencies fail miserably and destroy shareholder value. The book argues for a “pure play” structure in business, sticking to areas you have most competence in. For Shell this is oil and gas exploration, production, refining and marketing, which it is basically still going to do, albeit under a new set of fancy divisional names.

At the moment, The Global Investor is tending towards the strategy promoted in Focus. A related philosophy that makes me prefer Shell is from William Thorndike’s book The Outsiders which profiles unconventional CEOs who excelled at capital allocation. Can we be confident that Looney, who comes from the Upstream division of BP, will allocate BP’s capital to renewable energy better than van Beurden (who came from Shell’s Chemicals division) can allocate Shell’s capital to hydrocarbons? BP’s transition is just bound to destroy shareholder value. BP even admitted itself that a McKinsey study found that the vast majority of corporate restructuring efforts fail (if anyone has seen this study, please can you put the link in the comments section, as I am very keen to read it)! Shell’s share price might get depressed in the short term as ESG investors sell out, but that will just create higher returns for patient shareholders who care about cash returns, that Shell will likely be patiently generating.

Stick to what you are good at, return cash to investors, and let investors diversify by themselves. The Global Investor would much rather own a portfolio of pure plays such as Shell and Orsted and Vestas Wind, than have one larger position in just BP. BP will be trying to motivate its key oil and gas staff at the same time as running the business down, while at the same time investing in brand new areas it didn’t really do before. This means Shell, while it won’t win awards for ESG, it will probably provide better returns to shareholders. And with companies like BP getting out of oil and gas, all else equal, oil and gas supply goes down, which means oil and gas prices go up, which benefits the companies like Shell who have gained market share in an environment of better pricing. Meanwhile, Shell’s 4% dividend growth target cements its near-term commitment to shareholders.

Resource positions -> Market positions

Shell mentioned several times “value over volume” in its strategy presentation and it showed that over time it will move from going for “resource positions” and start looking more at “market positions”. This might mean it has less focus on oil and gas exploration for the sole purpose of booking reserves but instead become a bigger player in LNG shipping and trading. That is just fine because demand for natural gas will probably grow over time (as the electricity sector demands more of it) while oil demand will probably decline. Shell is not denying the energy transition is real, it is just approaching it in a way that maintains its own competitive advantage.

Ultimately, while Shell isn’t running its business for cash and winding down its businesses, at least just yet, it isn’t taking the risk of betting big on new businesses, as Al Ries advises against.

Many ESG conscious investors will not like Shell’s apparent “business as usual” approach. The big UK institutional investor Aviva Investors said last week it might dump shareholdings in slow-moving carbon emitters. That reminds me of Ben Graham’s Mr Market who frequently gets emotional. Smart investors will take advantage of Mr Market.

Conclusion

So ultimately, while I am not bullish on every single aspect that I saw in Shell’s Strategy Day, it was satisfactory and I stand by my call of not selling Shell. BP’s strategy is perhaps more circumspect, and we will come to that in another article in the near future.