Shell Looks Compelling as It Restores Full Cash Dividend

Shell recently announced it would restore its full cash dividend with the fourth-quarter payment. The decision came earlier than we expected but is not entirely surprising as we estimate Shell's break-even at $50/barrel next year. Shell also increased its annual organic free cash flow target by $5 billion for 2019-21 and reiterated its plans to repurchase $25 billion of shares during the next three years.

With the BG acquisition in the books, Shell is taking the necessary steps to compete in a world of $60/barrel oil. Like the rest of the integrated group, Shell is working to reduce its cost base by cutting headcount and improving its supply chain. The integration of BG is key to Shell's efforts, as it holds the potential for significant cost-reduction synergies. Furthermore, the addition of BG's low-cost production reduces Shell’s per-barrel operating cost, which has ranked among the highest in its peer group. By the end of 2016, Shell had already reduced operating cost by 20% from 2014 levels, but further reductions are now possible.

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 the company spent in 2014. The sharp decrease should improve capital efficiency, but should not completely sacrifice growth. Cost deflation, improved performance, and design standardization have all meaningfully improved potential returns and reduced total project spend.

As a result of its collective 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.

We don't assign Shell an economic moat, because its asset base is not capable of delivering sustainable excess returns at our long-term oil price assumption of $60/barrel. It's true that the addition of BG Group 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, it's unlikely to result in sustained excess returns without higher oil prices or better than expected cost improvement.

That said, we think the market is underestimating Shell's potential today, even after the dividend announcement. With the B shares trading at about a 7% discount to our fair value estimate, we think it's a compelling opportunity.