Shell's Turnaround Underway

Results were strong across the board in the first quarter, with integrated gas and downstream posting increases as well. The upstream segment was the biggest contributor to the improvement, however, with earnings swinging to a $540 million profit from a loss of $1.4 billion last year. The increase in commodity prices was the primary driver, although volumes increased 6% too thanks to new field startups and an additional month of BG production.

The integrated gas segment benefited from higher prices and liquefied natural gas volumes, which led to an increase in earnings to $1.2 billion from $1.0 billion last year. In contrast to many of its peers, Shell handed in improved downstream earnings. Thanks largely to strengthen in the chemicals segment, downstream earnings rose to $2.5 billion from $2.0 billion last year.

Operating cash flow of $9.5 billion, an increase from $661 million the year before, resulted in free cash flow of $5.2 billion, which was more than sufficient to cover the cash portion of Shell’s dividend. The first quarter marked the third consecutive quarter where Shell could cover the dividend with free cash flow. With 1 million barrels of oil equivalent per day of new, higher-margin production representing $10 billion of cash flow slated to come on line through 2018, we anticipate cash flow generation to continue improving.

Shell continues to stand out as the most undervalued integrated we cover, as we believe the market is failing to recognize the improvement in operations and financial health. We think the quarter demonstrates the potential for improvement over the coming years. After updating our model, we have increased our fair value estimate slightly. Our no-moat rating is intact, but our fair value uncertainty rating has decreased to medium from high.

Integrating BG Is Key With the BG acquisition in the books, Shell is embarking on the steps necessary to compete in a world of $60/barrel oil. Like the rest of the integrated group, Shell is working to reduce its cost base, which has become bloated in the past five years, by reducing head count and improving its supply chain. The integration of BG is integral to Shell's efforts, as it holds the potential for $4.5 billion of cost-reduction synergies. Furthermore, the addition of BG's low-cost production reduces Shell's per-barrel operating cost, which ranked among the highest in its peer group. Shell has already reduced operating costs 20% between 2014 and the end of 2016, but further reductions are possible in later years.

At the same time, Shell plans to dramatically reduce investment levels as new projects are completed by capping yearly capital spending at $30 billion through 2020, versus the nearly $50 billion it spent in 2014. The sharp decrease should improve capital efficiency but should not completely sacrifice growth. While the reduction in spending is in part a function of canceled marginal projects that are no longer economical, it also results from cost deflation, improved performance, and design standardization, which have meaningfully improved potential returns and reduced total project spending.

The impact is most notable in Shell’s future deep-water projects in the Gulf of Mexico and Brazil, where break-even levels have fallen to $45/bbl. The improved economics of deep-water projects--combined with projects nearing completion, high-return conventional reinvestment opportunities, and a large LNG portfolio (which does not decline)--means Shell can deliver modest growth at a reduced level of spending.

As a result of its efforts, including divestiture of capital-intensive low-return upstream and downstream assets, Shell should boost margins and improve returns by 2020, leaving it in a better competitive position. While we do not forecast the firm to achieve its goal of a 10% return on capital, it can realize its target of $20 billion in free cash flow with oil at $65 and some additional cost-cutting that returns upstream costs to 2011 levels.

No Excess Returns Without Higher Oil Prices In our view, Shell does not earn an economic moat because its asset base is not capable of delivering sustainable excess returns at our long-term oil price assumption of $60/bbl. In our evaluation of its oil- and gas-producing assets using our exploration and production moat framework, Shell's upstream portfolio rates feature some of the highest costs among its peer group, based on production and finding and developing costs. Its upstream returns on capital employed amounted to only 11% during the past five years, which is below average compared with other integrated firms. We think the addition of BG and its lower-cost asset base should improve Shell's competitive position and lead to improved performance. However, considering the price paid and the increase in capital employed, this purchase is unlikely to result in sustained excess returns without higher oil prices or better-than-expected cost improvement.

Similar to ExxonMobil XOM, Shell’s downstream segment consists of a large refining footprint that is integrated with chemical manufacturing. However, Shell has more exposure to Europe, where refining margins are likely to remain under pressure, and less in North America, where there is a feedstock cost advantage. Its level of chemical integration is also well below Exxon’s. During the past five years, its downstream return on capital employed has averaged 9%, less than half that of Exxon.

We recently revised our moat trend rating to stable from negative, as we expect the trend of ever-higher-cost reserve replacement to abate during the next five years. While we expect sustained lower oil prices and the addition of the higher-cost projects to result in returns on average remaining lower than in the past, we forecast Shell’s underlying cost structure and capital efficiency to improve from current levels. The improvements stem from the collapse in oil prices, which has brought about several changes to the company and industry.

Most notably, previously marginal projects are either experiencing substantial cost reductions (typically a result of services price deflation or redesign) or are being deferred indefinitely. Also, past investment in capital-intensive projects, such as LNG, has increased Shell’s exposure to long-life resources, which do not decline and require little reinvestment. These projects may deliver lower full-cycle returns, given the high up-front capital cost, but as the capital base is depreciated and cash flow remains steady, returns should improve. These projects also sit upon large pools of resources offering low-cost replacement opportunities. Collectively, these changes mean Shell can meaningfully reduce future capital spending compared with the past several years while maintaining production and reserve levels.

On Track to Reduce Leverage Shell's profits and cash flow are largely tied to oil and gas production and would suffer as a result of any material fall in pricing. Additionally, long-term price depreciation would expose the company to weakening returns on capital, as new projects coming on line would be unlikely to generate their projected economic results. Shell employs large amounts of capital in building out its production portfolio, and cost overruns and/or completion delays are continued sources of uncertainty. Shell's oil and gas production involves operating in politically unstable regions where leaders and members of the population can be hostile toward Western energy firms.

The drop in oil prices and subsequent acquisition of BG has nearly doubled Shell’s debt levels since 2014. At the end of the first quarter, Shell’s gearing ratio stood at 27%, a reduction from its peak, but still placing it toward the higher end of its peer group and the upper end of the company’s target range. To reduce leverage, Shell plans to sell $30 billion worth of assets by the end of 2018. Assuming it does so and applies all proceeds to debt reduction, the gearing ratio could fall to a more comfortable 22% by 2019. Although the $30 billion target initially seemed aggressive, Shell looks on track to execute it with $20 billion of sales announced already.

After debt reduction, Shell prioritizes paying the dividend. In an effort to preserve cash, Shell currently offers a scrip dividend, but we anticipate that it can return to paying a full cash dividend by 2019 with an improvement in operations and a recovery in oil prices. By our estimate, Shell can cover a full cash dividend with free cash flow at oil prices of $58/bbl beginning in 2018, which is one of the higher cash break-even levels in the peer group. While our forecast for oil prices of $48/bbl in 2018 implies another year of the scrip, current strip prices are suggesting prices of $53/bbl. However, we expect there would need to be a sustained price recovery to at least $60/bbl to restore the full cash dividend.