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Shell Jumps Out Of Fire And Lands In The Frying Pan

Seeking Alpha

Shell Jumps Out Of Fire And Lands In The Frying Pan

Zoltan Ban: Nov. 19, 2021
  • Shell’s move to exit the Dutch tax and legal jurisdiction is officially presented as an issue of dividend taxation that Shell and others hoped for years to see it repealed.
  • Though it is not much discussed by Shell or the media, the harsh environmental ruling by a Dutch court that forces Shell to cut emissions may have played a role.
  • Even though Shell is not currently faced with similar legal pressures in the UK, it may nevertheless feel other pressures to cut emissions by a similar margin.
  • Shell’s upstream segment is the most likely part of the business that will be sacrificed to environmental pressures.
  • Shell will most likely try to adapt its LNG and petrochemicals sector to lower emissions, that will make it less profitable. Higher natural gas prices will add to profitability concerns.

Investment thesis: Shell (RDS.A), (RDS.B) is leaving the Dutch legal jurisdiction, officially due to some dividend tax issues and it will make the UK its sole home base. Unofficially, it may be in large part a way to escape a court-imposed emissions reduction demand on its business activities. While the move to escape a legally binding cut of 45% compared with 2020 levels by 2030 is potentially avoided through this move, the internal, as well as external pressures for it to cut emissions, hydrocarbons production, and so on, will not cease.

The UK is a very ambitious player in the emissions reductions game, with its reduction targets being even more stringent than that of the EU. It is, therefore, more than likely that legal demands on Shell will return, while social pressures may actually be even more intense in the UK than they are in the Netherlands. As a result, its upstream sector will be allowed to shrink, given that Shell lacks reserves to maintain production, and spending more on acquiring reserves or making new significant discoveries is not likely to happen. Its LNG, as well as petrochemical sectors, will be maintained and adapted to lower emissions, at some cost. Higher natural gas prices for the foreseeable future may further bite into profits in both sectors, calling Shell’s future profitability prospects into question.

Official statements hide the real reasons behind Shell’s withdrawal from Netherlands’ legal & tax jurisdiction

In response to Shell’s cited reason why it is moving out of the Netherlands, namely its 15% dividend tax, the Dutch government is reportedly scrambling to ditch the tax. It is hoped that Shell will change its mind if the tax is scrapped. The much larger issue that seems to be largely understated, is the recent Dutch court ruling that obliges Shell to reduce its emissions by 45% by 2030. It is unclear whether this move will be legally sufficient for Shell to escape the Dutch legal jurisdiction. It may be that once Shell removes its tax status from the Netherlands, the only legal entity that will still be liable to the Hague court ruling will be its operations in the Netherlands. Given the current plans to cease production at the largest Dutch gas field, which Shell currently still has a 50% stake in, it should not be very hard to reach that goal of reducing its emissions exclusively for Shell’s Netherlands operations.

UK ambitions in regards to cutting emissions are even more drastic, which might leave Shell stuck with similar demands made on its operations down the road as it faces in the Netherlands

The EU is looking to cut emissions by 55% from 1990 levels by 2030. As of 2019, its emissions were 24% below 1990 levels. The target seems drastic, except that its recently departed former member, the UK has an even more ambitious target of reducing emissions by 78% compared with 1990 levels by 2035, and by 68% by 2030. I find it hard to believe that in such a political environment, the UK government will not go after multinationals based in the UK, asking them to cut their emissions as well, not just in their UK operations but also for their global operations. UK courts may also weigh in, as the Hague court did in regards to Shell.

Even if it will not be faced with similar court decisions any time soon, and perhaps it will be a while before the UK government will start pressing UK companies to align their emissions ambitions with those of the UK government, the political and social mood is clearly one where public pressures will weigh heavily on companies headquartered in the UK, like Shell.

Effects on Shell’s long-term outlook

The investment community seems to have greeted Shell’s move with some cautious enthusiasm, with its stock experiencing a bump in the hours after the news broke that it is leaving Dutch jurisdiction. Some may believe that with this move, the pressures that Shell is experiencing to become something different from a business point of view than it currently is will subside somewhat. Shell cannot claim this to be the case, even if it may be behind its decision, because of the potential for public backlash, but such calculations may have played a decisive role. It may indeed be the case that Shell will not get much of a long-term reprieve from those environmentalist pressures, even if this move might buy a few years, thanks to its move out of the jurisdictional range of the Hague court.

In its latest quarterly report, Shell announced that it will cut its emissions from its operations by half compared with 2016 levels by 2030, which more or less corresponds to the demands of the Hague court. The difference is that a self-imposed target provides a little bit more wiggle room, where a reduction by a third or more in emissions will more or less suffice for Shell to be able to claim that at least it tried really hard.

Shell may in fact not have to try too hard to cut its emissions from its upstream operations, because it increasingly lacks the oil & gas reserves needed to sustain those upstream operations.

Given that Shell is unlikely to continue with acquisitions of new reserves, and prospects of new discoveries tend to be very poor industry-wide, it is possible that by 2030 its upstream production will decline drastically from current levels. Emissions from its upstream operations will probably decline accordingly. Unfortunately, with this decline, Shell’s revenues from oil & gas sales will decline accordingly. In the third quarter of this year, it realized net earnings of $1.7 billion from its upstream operations, on revenues of $4.7 billion. It is impossible to predict just how low Shell’s upstream production will go by the end of the decade, but it is increasingly clear that it will be on a constant declining path for much of the decade and beyond. The silver lining is that Shell will not spend a lot of money on maintaining its upstream business going forward, whether on acquisitions, discoveries, and even on enhanced recovery and improving emissions on upstream activities.

Shell’s petrochemical, refining, and LNG operations brought in $3.3 billion in net earnings for the third quarter. I don’t think that Shell will be as eager to shrink these sectors going forward. With the upstream sector, it increasingly has little choice, because it is hard to secure viable resources for reserve replacement, which is an industry-wide phenomenon. LNG in particular is just now starting to show the critical role it will play in a world where growing reliance on intermittent sources of energy such as wind & solar may cause sudden national or regional demand spikes for natural gas. The EU energy crisis, in part triggered by a sustained shortfall in wind & hydropower electricity generation, served to highlight the fact that the world needs to have the ability to shift supplies from one region to another, and not only rely on piped natural gas, even if it tends to be significantly cheaper. LNG prices have been headed higher this year, because of the growing demand for supply flexibility. Shell controls about 20% of the world’s LNG shipping capacity, and I imagine that it will want to retain its dominant position. LNG revenues were nearly equal to Shell’s upstream revenue in the third quarter of 2021.

Its petrochemical strategy was also something I found to be an attractive feature of Shell’s overall business model. For instance, Shell’s investment in a massive petrochemical plant close to the Appalachian shale gas fields, as opposed to investing in producing shale gas in the area, where most producers found it hard to break even for most of last decade, showed good strategic planning. It certainly makes more sense to invest in value-added operations that can take advantage of low prices caused by a temporary regional supply glut than it does to invest in natural gas extraction assets that contribute to the glut.

Both sectors have a lot going for them. The problem for Shell is that it is faced with severe pressures to show a significant reduction in emissions from its operations. In the case of LNG and petrochemicals, which Shell should ideally try to preserve or even expand, it would involve massive investments in emissions reductions measures. In the case of some assets, such as LNG transport ships, it is not entirely clear how Shell will be able to go about reducing emissions. LNG production facilities and Shell’s petrochemical plants could resort to installing solar panels and so on, for the purpose of producing at least some of the energy needed to run those plants. Transport trucks could potentially be switched to electric in time. These are all remedies that will require significant investments without seeing a significant increase in revenues and profits as a result. In Europe, Shell may be able to access subsidies meant to help industries cope with the stringent emissions reductions demands. I am less certain about its operations outside of Europe.

It is impossible to calculate the magnitude of the costs that Shell will incur this decade in order to make its operations greener, but Shell may also get squeezed from other directions indirectly. We can expect a massive loss in revenues and profits from its shrinking upstream sector, although some of the revenue may be made up from potentially higher average oil & gas prices going forward. Shell’s petrochemical and LNG sectors may feel squeezed from those same higher natural gas prices. We should keep in mind that it is not just Shell that is feeling pressure to reduce their oil & gas operations. The entire Western oil & gas industry is feeling pressure in this regard. There are government pressures, social pressures, internal pressures on their own boards, as well as ESG pressures. This all translates into constrained global supplies for oil & gas. If demand were to also decline accordingly, then things would be alright going forward, but I expect natural gas demand, in particular, to continue expanding globally for the foreseeable future. Shell is therefore set to be particularly vulnerable to those price increases because its LNG and petrochemical operations are heavily dependent on cheap natural gas. I personally wonder if between the higher cost of natural gas inputs that I expect to see and also the extra costs involved in greening both sectors of its business if Shell will be able to still produce much of a profit from either one of these two crucial units of its business.

Some green projects do have potential business merit

Where I do see some potential upside for Shell, is its EV charging stations plan. This is very straightforward. It already has an extensive network of gas stations. It can use those existing properties to create dual fueling stations, where one can stop for gasoline, diesel, or for an electrical charge. Subsidies may be available in Europe as well as in North America, therefore the costs of implementation may not necessarily be very high. It is also true that it may not necessarily translate into a lot of extra business. It may just be that gains in EV customers will be offset by losses in ICE-powered vehicle customers. At the very least, such a plan will ensure that there will not be a loss in total customers and in overall business volume at its chain of gas stations.

Shell is also exploring the hydrogen business, which in my view is set to grow exponentially this decade, given what we learned this year in regards to what it means to become increasingly reliant on intermittent renewable electricity being fed directly into the grid. Europe’s shortfall in those renewables this year, which led to a dramatic increase in natural gas & coal demand, exposed the need to transform at least some of that electricity produced from wind & solar into another form of energy that can be stored for prolonged periods and transported. In a world where we are set to increasingly rely on renewables, we may need to be able to shift energy supplies across nations and even continents. Hydrogen is the most logical option in this regard. Shell is currently running a few projects related to this potentially exponentially growing industry, where it is producing hydrogen from wind energy and it is likely to expand such operations in coming years.

The potential problem with Shell’s green hydrogen projects and plans is that this decade it may face stiff competition from producers of hydrogen derived from natural gas. Russia for instance has a very ambitious goal in this regard. Assuming that market conditions will prevail, hydrogen production projects that rely on natural gas are likely to outcompete those who will produce it from renewable electricity, through hydrolysis. The equation may change if other factors such as subsidies as well as trade tariffs are factored in. It remains to be seen how this issue will play out. The hydrogen space looks promising for Shell, but there are still many questions that need to be answered before we get ahead of ourselves and declare it to be a sure thing, with revenues and profits just waiting to pour in.

Shell investors probably could have used some good news after the rather disappointing Q3 results. A net loss is most certainly not what was expected, with oil & gas prices rising, and the LNG market booming. As it turns out, its LNG situation led to the loss, given that it lacked enough LNG to meet obligations and had to buy additional supplies at very high costs in order to meet those contracts. Hope that Shell’s longer-term prospects may improve on the back of a less stringent and more flexible emissions reduction strategy as a result of its move to get out of the Netherlands may have prompted some investors to re-evaluate Shell’s long-term outlook. In my view, while there is some flexibility and perhaps some time gained as a result, the environmentalist pressures are still there, and they will continue to be a drag on Shell’s longer-term prospects. As is the case with many other oil and gas producers headquartered in the Western World, it is facing an increasingly impossible situation. Shifting its legal status from one Western nation to another will not do much in terms of helping to alleviate the pressures and the likely financial pain the company and its shareholders are set to face.


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