The chasm between the immediate term picture and the long term outlook for oil supply is widening. Oil has dipped below $50 per barrel as the global slowdown gets into full swing as the dangers for future production increase. For Royal Dutch Shell (LSE, RDSB) a dip in production has been more than offset by higher energy prices and, an armed with a substantial war chest, the oil major still looks set for a period of sustained out-performance.
Recently released third quarter results illustrate the benefits of integration. Whilst production dropped 10 percent, Shell’s downstream operations have reported higher marketing margins, higher refining margins and trading contributions, despite low refinery intake and increased operating costs.
Much to the dismay of motorists, integrated producers such as Shell are able to mitigate any production shortfall by targeting higher margins at the pump. Members will no doubt be aware that oil companies without downstream operations have been hit for six by the global slowdown.
While governments worldwide dot the i’s and cross the t’s on fiscal stimulus packages, there are no signs of an immediate turnaround. In the US rates are already down to 1 percent and the UK could be headed that way.
As we have stated previously, current measures will not be enough to revive that US economy and further action will have to be taken. As far as oil consumption is concerned, the International Energy Agency today slashed its 2009 oil price forecast to US$80 from $110 stating that emerging economies may not be as immune as once thought.
The Chinese have acted swiftly and with purpose. The stimulus (close to $600 million) is large and in our view will serve its purpose of keeping growth at around 8 percent. Remember the China growth story is driven by domestic demand and is not as dependent on exports to the US as it once was.
Chinese oil demand is set to grow by 3.7 percent next year. Whilst this is an estimate which has been revised down, demand is still growing despite the world around it falling apart. And once the recovery begins, we expect China and co to resume double digit growth levels which will have an upward effect on oil consumption.
In a couple of years though, we could be looking at an entirely different picture on the supply front. Today’s oil price is making investment economically unviable, which in turn is set to shrink the production of tomorrow. Consumption of tomorrow is far from shrinking and the IEA expects demand for oil (led by the emerging economies) to reach over 106 million barrels a day in 2030 (versus today’s 85/86 million). This is good news for Shell, not to mention the robust outlook for gas.
Despite its recent bout of strength, another factor which underpins our bullish stance on oil and commodities generally is the inflationary pressure which is set to dominate the US dollar.
With US interest rates down to 1 percent, the liberal monetary policy will filter through to the dollar over the mid to long term. And as the smoke pours from the greenback printing machine, we remain convinced that oil and commodities generally priced in US dollars are set to increase in value.
So all in all, good news for oil cost efficient oil producers. And in a market where oil ‘must’ hold above $100 per barrel, we believe that high quality integrated producers such as Royal Dutch Shell will continue to generate solid earnings.
Shell’s recently released third quarter results emphasised this very point. The group’s earnings came in at US$10.9 billion compared to US$6.4 billion a year ago on a current cost of supplies basis. The 74 percent jump came in some US$3.7 billion ahead of analyst expectations.
Furthermore, cash flow from operating activities (a real barometer of health), excluding net working capital movements, was $10.4 billion compared to $9.9 billion for the same quarter last year.
Despite these figures, the charts suggest that the market remains worried about near term oil demand.
Following our last review in August, Shell extended the fall to a low of $41.85 in October, before rebounding as high as $60.05 during the past week. Unfortunately, the strength of the US dollar has prevented the US listing performing as well as the UK listing of the stock.
As visible on the weekly chart, considerable resistance remains overhead in the region of $62.20 to $63.42. While below this barrier, rally attempts are likely to struggle.
Shell can do little to control the state of the world economy, but must keep its operations in check whilst the clouds hover. And overall, Shell’s broad group of businesses showed tremendous strength, with the Chemical and Corporate divisions being the only laggards in the group.
Shell’s exploration and production division’s earnings rocketed despite the drop in output. Indeed, earnings of US$5.5 billion compared favourably to $3.3 billion in the corresponding quarter last year.
Total oil and gas output, including oil sands bitumen production came in at just under 3 million barrels of oil equivalent per day (boepd), compared to 3.14 million boepd in the same quarter last year.
Production may have dropped 120,000 boepd when compared to the corresponding quarter last year, but we are not overly concerned. Hurricanes in the Gulf of Mexico as well as a shutdown of the St. Fergus gas processing facilities were the primary factors. Excluding these factors and production was just 1 percent lower.
"..we expect China and co to resume double digit growth levels which will have an upward effect on oil consumption."
Shell has taken significant strides operationally, but results were also aided by a climate of high oil and gas prices. Indeed the average price realised for oil was just over $111 per barrel, an increase of 58 percent on last year. Gas followed suit jumping 48 percent to 6.77 per million cubic feet.
Elsewhere, third quarter Gas & Power segment earnings were US$2,774 million compared to US$568 million a year ago. Whilst Oil Products CCS segment earnings were $2,304 million compared to $1,651 million in the third quarter 2007.
Meanwhile, the Oil Sands division continued to flourish and upgrader availability was up at 96 percent from 90 last year.
A driver behind Shell’s continued success has been its dynamic portfolio and its aggressive capital expenditure programme. During this years third quarter, both were in full effect.
Net capital investment for the quarter was an impressive $11.2 billion. This includes proceeds from sale of the BEB Erdgas und Erdoel GmbH of around $1.4 billion.
The recent purchase of Duvernay, the Canadian tight gas company set Shell back a cool US$5.5 billion. We believe it is an astute use of capital and the company now boasts a Canadian resource base of over an estimated 1 billion barrels of oil equivalent.
Meanwhile in Australia, the company is now officially partners with Arrow Energy Ltd. The two will develop projects to extract clean-burning natural gas from coal deposits.
Encouragingly, in the UK, Shell announced the start-up of the Curlew C field, which will take its expected aggregate peak production capacity from its 4 North Sea fields added this year to 30,000 boepd.
So it is clear to see that the company remains firmly on the front foot.
Shareholders will no doubt be buoyed from the latest dividend. Indeed, the company has bolstered its dividend to 40 cents per share. This represents an 11 percent jump from the corresponding period last year.
From a valuation perspective, we believe that Shell is currently trading on an undemanding prospective PE of only around 5 times whilst also yielding over 4.5 percent.
We have used the primary (UK) listing for our longer-term analysis. As shown although the stock has largely moved sideways for the past nine years, the overall bias remains to the upside. Accordingly, we believe that a continuation of the longer-term upward trend is achievable in due course.
Shell continues to defy analysts’ expectations. Its integration and diversity stand it in good stead for periods where the prices for its products may not be so high. The company’s aggressive investment programme will ensure that production targets are continually met and will underpin strong earnings ahead. Shell in our view represents excellent exposure to long term strength in oil and gas prices.
As such, Royal Dutch Shell will remain firmly held in the Fat Prophets Portfolio.