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Stock Strategist

Improvement in North America Means Brighter Days for Shell

We think Shell's valuation is the most compelling of the oil majors.

 Shell (RDS.A)/ continues to see results hurt by headwinds that aren't going away soon: high exposure to North American shale gas, a structurally weak downstream business, and setbacks in its Alaska drilling program. But with the exception of weak downstream fundamentals, we believe these headwinds will improve from here, and our long-term outlook for modest production and dividend growth remains intact. Given the recent runup in Chevron's (CVX) shares, Shell has become our preferred oil major based on valuation.

To us, the most pressing question is how long it will take before Shell can begin to improve results in its Upstream Americas segment. There are several reasons to think a multiyear recovery is set to get under way soon. These include rising natural gas prices, declining nonproductive capital, and production growth now squarely focused on oil (Gulf of Mexico and Permian/Eagle Ford). Returns will be challenged in the Americas for some time, but we sense shares could react favorably as it becomes apparent that results will significantly improve without the need for liquefied natural gas export projects. We expect these improvements will start to surface by the end of 2013.

Despite Shell's recent setbacks, our long-term company outlook is unchanged: Heavy investment will drive modest production and cash flow growth, as well as slow and steady increases to the dividend. Returns are unlikely to be spectacular, and the oil majors as a group face many challenges, but our valuation has long assumed as much. For investors looking to add exposure among the oil majors, we think Shell's valuation is the most compelling.

Among the higher-yielding European majors, only BP (BP) is more likely to increase its dividend faster than Shell. But BP's growth is accompanied by a lot of risk from Macondo liabilities and Russian sovereign exposure. Adjusting for this, we think Shell's combination of higher yield and growth is still the top dividend play in mega oil. Dividend increases are likely to remain modest, given the conservative nature of Shell's board, which aims to never cut the dividend, ever. The company plans to raise its payout 5% this year, and with operating cash flow set to average $46 billion annually, we think investors can expect similar growth in 2014-15 if oil prices remain at or near current levels.

Upstream Americas Will Soon Begin to Improve
Upstream Americas is the weak link in Shell's oil and gas portfolio, using 40% of capital employed but generating just 3% of 2012 adjusted profits. The biggest problem by far has been North American natural gas, which represents 40% of Americas' production, most of which is coming from shale. Low prices and high depreciation are making Shell's shale dry gas production very unprofitable, and this has in turn weighed on returns. This is in stark contrast to the company's Upstream International segment, where returns on capital employed were a robust 25% in 2012.


Source: Morningstar Equity Research.

Entering 2013, Shell had $28 billion in capital employed in unconventionals, most of which is North American dry gas. Investors could forgive poor returns today if production growth were forthcoming, but the poor economics North American gas has generated of late has forced Shell to hit the brakes hard. Company guidance implies 8-9 dry gas rigs will be running in 2013, compared with 31 throughout 2011. This means production from dry gas shale is likely to start falling at some point in late 2013 or early 2014.

That's not necessarily a bad thing longer term, but it does mean a fair amount of capital will remain tied up in undeveloped resources. Entering 2013, roughly half of Shell's $28 billion in unconventional capital had yet to produce oil or gas. With a majority of this $28 billion being in dry gas plays, holding back on expanding gas production will act as a drag on returns for a while longer. This dynamic is well understood and, in our view, is indeed weighing on sentiment as investors rightly sense Upstream Americas will be challenged for some time to come.

But we believe results are finally reaching bottom, and we see several reasons they will improve from here. Looking at Shell's activities in the Americas, we believe a few key areas should help returns and profits begin to trend up. Rising natural gas prices offer the most obvious and significant uplift to returns, with management recently stating that $1 increases in Henry Hub would lift annual profits by $400 million. Another key area will be lowering the $14 billion of nonproductive shale capital. This nonproductive capital isn't going away completely, but we still expect it to fall a good deal during the next couple of years. Shell is now active in more than a dozen North American shale basins, and in the majority of these it remains in exploration/appraisal mode. This is likely to change in the next 12-18 months, as the company aims to move a larger proportion of its shale plays into development mode, including shutting down activities in basins with poor economics if need be.

Shell's shift to production growth via oil rather than gas will also help. In the Gulf of Mexico, we expect oil output to increase by 78 thousand barrels a day by 2015 compared with last year thanks to the startups of Mars B and Cardamom. Oil production will also grow from increased activity in liquids-rich shale, where Shell now has 30 rigs running (primarily in the Permian and Eagle Ford). We forecast liquids volumes from these plays to collectively grow to 81 mb/d by 2015 from 11 mb/d in 2012.

Finally, the recent acquisition of Repsol's South American LNG assets will immediately be accretive to 2014 profits and returns. Repsol disclosed EBITDA from these assets was expected to be $850 million in 2013, but Shell thinks it can increase this to $1 billion once the 1.8 metric tons per annum of LNG volumes are in Shell's global LNG trading and marketing portfolio.

Of course, this falls well short of turning around this segment completely. But after two quarterly losses in a row, we think the Americas are fast approaching the point where the best assets begin to outweigh shale gas, rather than vice versa. We get the sense that shares could react positively once it becomes clear that returns and profits are about to begin a multiyear upward trend, and we think this upswing will begin before the end of 2013.

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