27 February 2018


by Blake Allen

This note revisits our investment thesis on Royal Dutch Shell PLC (RDSB LN), which we currently consider to be a ‘core holding’. The basic valuation thesis is as follows: on reasonably conservative energy price assumptions, Shell could significantly grow its Free Cash Flow (FCF) over the next 2-3 years. This should underpin, by our estimates, an IRR to investors of c. 20-25% p.a. Should a strong growth environment persist for longer than we expect, there is meaningful upside potential to this return estimate. Conversely, if GDP growth softens, Shell’s defensive properties (the company’s ability to maintain its dividend in a down-cycle) should actually underpin the share. The dual-character of this investment thesis, that it works in “both worlds”, is key to its attractiveness at present, when investors are caught between a currently strong growth environment and concerns that the cycle is reaching maturity and due a correction.

Shell has provided guidance on their expected organic FCF in the 2019-2021 period, as well as anticipated buybacks and the oil price assumption in this guidance (Figure 1). By crunching through these assumptions with reference to the current share price, and a range of possible “fair FCF” assumptions in 2020, one can generate a range of possible IRRs (Figure 2). The company’s FCF guidance is based on $60/bbl for Brent; rather conservative vs. where it trades at present (~$67/bbl) and, we think, fair if not slightly conservative in the medium to longer-term. This is an attractive range, but naturally the picture is a little more complicated than this. Here, then, are some of the details.

Like any company, Shell’s fortunes will be driven both by company-specific and by macro variables. Regarding the former, we think Shell is delivering operationally, and has the potential for further efficiency improvements under the excellent leadership of Ben van Beurden (CEO since 2014). The latest quarterly results for Shell to end December 2017 provided clear evidence of the ongoing improvements in the business. Van Beurden has an absolute focus on creating a best-in-class company on the global stage.

Figure 1: Shell’s recent operational guidance

In addition to company-specific factors, Shell’s share price is driven to a significant degree by “macro” variables, in particular the oil price and interest rates. These exert themselves differently at different points in the cycle. At present, we expect an environment of modestly rising interest rates, and continued good economic growth for at least the next 12-18 months. This means that we think economic fundamentals will allow Shell to deliver its expected FCF guidance during 2019-2021 (i.e. we think a Brent price of $60/bbl is a reasonable and quite conservative assumption); but also that rising rates will, at the margin, reduce the attractiveness of the stock as a bond proxy. That these macro variables assert themselves in opposite directions is key to the attractiveness of the stock.

If our macro outlook proves incorrect, and growth softens during the next 12-18 months, bond yields are likely to fall meaningfully, and Shell will then probably be priced as a bond proxy. That it has both cyclical and defensive properties means it is a good kind of exposure to the broad category of “resources”; that is, it is far less likely to fall off the proverbial “cliff” if commodity prices suddenly soften. This double quality is actually built into Shell’s strategy, which aims for “surplus free cash flow in [the] up-cycle and dividends fully covered in [the] down-cycle”. Thus, while FCF guidance is based on expected prices ($60/bbl), project execution is shaped by a meaningful margin of safety, with project break-evens largely below $40/bbl in upstream (see Figures 3 and 4). As the dividend yield is actually 6% at current prices (vs a 10-year bond of around 2.9%, but likely to be closer to 1% if growth deteriorates), the stock is likely to be resilient if an economic downturn should arise (not our base-case for the 12-18 month outlook), provided it is indeed able to deliver this down-cycle objective.

Figure 2: Anchor estimates of return outlook

What’s a fair FCF-yield in 2020? There are three key assumptions in our valuation: (1) the oil price; (2) that management continues to deliver operationally; and (3) the fair FCF yield in 2020. Here, we focus on the third assumption. It will principally be driven by the quality of cash-flows (how resilient they are), and whether they are likely to keep growing in the longer term. Medium-term growth is already reflected in our 2020 FCF estimates; in the longer-term, management have noted their intention to grow organic FCF beyond 2020. But, more concretely, there are important growth assets in the portfolio that are not reflected in positive FCF estimates for FY2020 (more on this below). Regarding earnings quality, the factors which differentiate Shell from a typically commoditised business (the default assumption for resource companies), by business segment, are as follows:

(1) Upstream: Although this business produces both oil and gas, the latter is largely priced w.r.t. the oil price. In integrated gas, Shell’s portfolio includes the world’s largest GTL plant, named “Pearl”, which includes about 3,500 patented processes. This segment looks attractive, both in terms of economics of scale, and patent protection. The competitive structure of the oil market was until quite recently an “oligopoly”, with OPEC having sufficient power to influence prices such that the industry could expect, in the medium to long-term, to earn “economic profits” above its cost of capital. The entry of US shale changed this equation, threatening to wreck its barriers to competition, and push expected ROEs down to industry cost-of-capital. At present, OPEC has regrouped as the now larger “OPEC 2.0” (including Russia), while non-OPEC supply is now concentrated in seven large corporates (Exxon, Shell, etc.), having quite recently been highly fragmented. In short, this means the industry has better competitive dynamics than those apparent in a world of “perfect competition”.

Figure 3: Deepwater Project pipeline is profitable at low oil prices


(2) Downstream: the risk of commoditisation of the downstream businesses is also apparently low, as these businesses are more ‘industrial’ in nature, highly complex, and also leverage very significant economies of scale. What is perhaps most significant is the way upstream and downstream function in tandem to dampen overall volatility of returns, by capturing value as it moves up and down the value chain (e.g. falling oil prices weigh on upstream returns, but tend to see downstream earnings increase as refining margins benefit from lower input costs).

Figure 4: Oil & Gas project pipeline is also resilient at low prices

(3) New Energies: In considering the fair FCF yield in 2020, it is important to consider assets under development that will contribute to the growth outlook, but which are not yet generating FCF. Although New Energies is currently quite small, it represents a potentially very significant future business unit. Shell is leveraging its existing infrastructure to give itself a competitive advantage here. Thus, while Shell’s business could be segregated operationally (oil products, integrated gas, chemicals, etc.), the company also discloses a segmentation by “strategic intent”. That is, the business is divided into “cash engines”, “growth priorities” and “emerging opportunities”. New Energy falls into the latter category, expected to absorb cash in the near term, but of great significance on the longer-term strategic timescale.

Ultimately the fair FCF yield is a matter of judgement. Taken together, the above factors suggest we should be giving Shell credit for genuine embedded competitive advantages, in industries that are not commoditised but themselves have reasons to expect “economic profits”; furthermore that there is a good LT growth picture for the company. In our judgement, then, it seems prudent to take the middle-range FCF yield of 8-9% as a fair metric (this also reflects our expectation of the return-dampening effects of rising interest rates). This suggests the potential IRR for investors in Shell is about 20-25% p.a. in US dollar terms over the next 2 years. However, the risk/return equation is more important here, and Shell’s apparent resilience in a downturn is likely to be meaningful, this is due to its bond-proxy dynamics and resilient dividend stream.

The oil price, along with most risk assets globally, saw some price weakness in 1Q18. With generally recovering asset markets, and above-ground oil inventories dwindling, oil prices are again moving upwards. Note that our valuation thesis for Shell is actually predicated on lower medium-term prices than those currently evident (i.e. about $60/bbl in real terms).

Some of the medium-term fundamentals of the oil market are as follows. In the past three years, this market has largely been a tug-of-war between OPEC and US tight oil (also known as US shale, or ‘unconventional’ oil). What is distinctive about US shale is that it has a very short leadtime to production; thus the industry can respond very rapidly to price signals, thereby dampening the extreme boom/bust pattern than has typified the oil market in the past. Initially, US tight oil significantly damaged OPEC’s oligopoly lower, but the cartel has regrouped, and its latest supply restriction agreement includes a number of other nations, most significant of which is Russia. This broader group, dubbed “OPEC 2.0”, appears to have recovered some of the original OPEC’s lost oligopoly power.

Although shale efficiencies (e.g. barrels per new well) have continued to rise dramatically, costs have also risen significantly in the past 12-18 months, such that the 2017 shale cost curve has effectively remained in-line with 2016 levels. Up to 2017, the shale cost curve fell dramatically each calendar year. Further, the oil industry outside of shale has been remarkably successful at cutting costs: Shell recently noted that Deepwater project costs (per unit basis) are down by 45% from 2014 levels. It appears, therefore, that the cost differentials between shale and non-shale have converged to some degree.

The longer-term oil market will probably see demand growing by around 20mb/d over the next 20 years. Tight oil, however, can grow by only about 5mb/d over that period. Thus, while the ability of shale to dampen price spikes in both directions is acknowledged, it appears that this unconventional source of supply does not have the ability to push the longer-term market balances into oversupply. The oil market is also unique in that its supply dynamics are determined not only by corporate profitability concerns, but also by national budgets in major producer countries. These countries tend to act to support prices in unbalanced markets.

A second important macro variable is the interest rate outlook. As Shell trades on a very attractive 5.5%-6% dividend yield, its share price has been meaningfully driven by interest-rate dynamics. We do expect interest rates to rise gradually over the next 12-18 months and this has been reflected in our valuation estimates (i.e. in the fair FCF yield in 2020). A spike in rates, well above our estimates, could result in actual returns being lower than we estimate. We do not expect such a rate-spike, however, because of the currently very high levels of global debt.

A key risk to our valuation thesis for Shell stems from the possible macro environment which would hurt both sides of their “dual” financial strategy: that is, if oil prices soften, but inflationary pressures persist in spite of this deflationary development. This could result from, say, a very strong supply-side response in oil production, and inflation pressures deriving from tightening labour markets, or other sources not connected to oil. However, as we find good evidence of real prudence on the supply side, as well as potential Shale supply being limited in its ability to glut markets, we think the scenario of oil price weakness, resulting from excessive supply growth, in tandem with a rise in global inflation, to be possible but not likely. In short, we find Shell to be an attractive value proposition, both under our base-case assumptions, and in other possible futures that deviate from our outlook.

Figure 5: Further detail on our expected investment IRR



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