Shell’s Q3 Overshadowed by Talk of Unlikely Breakup

Shell RDS.A RDS.B reported third-quarter results that were much improved from the year before, albeit below consensus. The business benefited from high oil and natural gas prices during the quarter to deliver a whopping $17.5 billion in operating cash flow, before working capital, a record. Although $4.0 billion was related to derivatives, which is likely to roll off in coming quarters. Adjusted earnings increased to $4.1 billion from $955 million a year ago, but below second-quarter levels on Hurricane Ida effects and weaker trading results. Earnings were a bit weaker than expected given difficulty with third-party supplies in the liquid natural gas segment, which forced Shell to buy in the spot market, an issue which will likely persist until early next year. The company repurchased half the planned $2 billion for the second half of 2021, with $7 billion more coming in 2022 with the closing of the Permian sale. It will review its shareholder return plans in the fourth quarter, which will likely result in more repurchases given the recent strong cash flow. Gearing fell further to 25.6% from 27.7% in the second quarter. Our fair value estimate and moat rating are unchanged.

More exciting, however, than earnings were reports on Oct. 27 that Dan Loeb’s Third Point had taken an estimated $750 million stake in Shell and called for a breakup of the company. Detailing his investment thesis in Third Point’s third-quarter letter, Loeb explained that Shell is cheap relative to peers because it has been unable to fully satisfy its myriad potential investor groups who are each looking for something different, be it cash returns, oil exposure, or renewable investment. In splitting the difference, Shell has appeased none. Instead, Loeb thinks Shell should split into two companies, one with the legacy hydrocarbon businesses (upstream, refining and chemicals) and the other holding the liquid natural gas, marketing and renewables businesses.

The former could reduce investment, divest assets and return cash to shareholders for redeployment elsewhere. The latter could invest aggressively in renewables and other low-carbon businesses.

The idea has merit, but we think it has a low probability of implementation. Without doubt, Shell has failed to satisfy its various stakeholders (shareholders, governments and so on), whose goals vary and are often in conflict. The lack of clear-cut appeal of the company as an investment has also kept investors away despite its recent strong financial performance and new strategic direction. CEO Ben van Beurden has faced similar calls before, but pushed back along two lines. First, to invest and grow the renewables and low-carbon business at the rate and scale it wants to, Shell needs the cash flow from legacy hydrocarbon businesses. Second, integration of the various businesses creates value as there are technical issues or opportunities where the newer businesses benefit from the expertise or facilities of the legacy businesses, for example, using offshore wind to power a hydrogen electrolyzer at a refinery to produce low-carbon fuels. Offering a variety of energy, also helps to better serve customers. A separate company would have access to neither the cash flow stream nor assets. He reiterated these points on the quarterly conference call.

Neither objection is insurmountable, however. As Loeb notes, the LNG/renewables/retail business could earn a lower cost of capital once it's free of the legacy oil businesses and could also face less difficulty in raising capital given its lower-carbon focus as it might attract some environmental, social, and governance-focused investors. Both would help mitigate the loss of oil cash flow. A split might also free the upstream business to move domiciles and better shelter itself from recent or future court rulings. This fact, along with Shell’s role as national champion, might mean government support proves an obstacle, however, if management decided to move forward.

Given management’s reluctance and some reasonable objections and hurdles, we think a separation is unlikely to occur. But the idea does have appeal given Shell’s poor past performance and the lukewarm response to its current strategy, so if Loeb can attract more supporters, pressure on management will grow. We believe the chance of a split is low, although, non-zero.

That said, Loeb might have done Shell a favor by highlighting how cheap the stock is. By his own calculations, the market is assigning zero value to the upstream, refining and chemical businesses, which still generate the bulk of operating cash flow. So, while a separation might not occur, share price appreciation could just be based on traditional business fundamentals.