Shell: New Strategic Direction Sets New Challenges For The Company

BMI View: In line with the industry trend of lower capex amidst an environment of higher costs and softer prices, Shell has announced a re-alignment of its strategy towards tighter capital allocation and control to improve its profit margins and earnings. With a portfolio of mega-projects due for delivery in the coming years we believe that Shell will be on a strong footing in the industry, especially if it lets go of assets that have been absorbing capital with uncertain or low returns. We see the divestment from European downstream as a good step in this process, but highlighting that the situation in Nigeria will most likely deteriorate an continue dragging down earnings in the coming months, while growing LNG exposure is the main risk we see for Shell in the long term.

2014 is going to be a transformative year for Shell according to the statements and plans presented by the new management team. The aim is to 'sharpen the focus' of the company so that it is no longer the laggard amongst its peers.

Though the US shale gas assets have been the weakest link in Shell's performance (yet again) in 2013, natural gas prices bottomed out in 2012 and our forecasts suggest that Henry Hub prices will be on an upward trend for the rest of the decade. This is creating an upside for Shell in a segment which we forecast will be entrenched in the future fuel mix of the US.

Shell - Laggard Of Its Class
O&G and S&P 500 Equities, 1 January 2013 = 100

Shell: New Strategic Direction Sets New Challenges For The Company

BMI View: In line with the industry trend of lower capex amidst an environment of higher costs and softer prices, Shell has announced a re-alignment of its strategy towards tighter capital allocation and control to improve its profit margins and earnings. With a portfolio of mega-projects due for delivery in the coming years we believe that Shell will be on a strong footing in the industry, especially if it lets go of assets that have been absorbing capital with uncertain or low returns. We see the divestment from European downstream as a good step in this process, but highlighting that the situation in Nigeria will most likely deteriorate an continue dragging down earnings in the coming months, while growing LNG exposure is the main risk we see for Shell in the long term.

2014 is going to be a transformative year for Shell according to the statements and plans presented by the new management team. The aim is to 'sharpen the focus' of the company so that it is no longer the laggard amongst its peers.

Though the US shale gas assets have been the weakest link in Shell's performance (yet again) in 2013, natural gas prices bottomed out in 2012 and our forecasts suggest that Henry Hub prices will be on an upward trend for the rest of the decade. This is creating an upside for Shell in a segment which we forecast will be entrenched in the future fuel mix of the US.

Of more potential (future) concern could be their growing exposure to global LNG, which nearly makes up a third of Shell's natural gas sales. This is a market with a far more nebulous prospect for profitability in several of the largest projects and therefore needs to be part of a balanced portfolio.

The downstream sector will be stagnant at best as IOCs (Shell amongst them) cannot compete with state-supported, new generation, mega-refineries located in the main consuming centres in China and the Middle East, although sweet spots in the US downstream sector provide pockets of opportunities and the margins Shell attained for the Gulf and West coast refineries reflect that.

Shell's pre-emptive announcement of a profit-loss for the fourth quarter and full year 2013 paved the way for a sombre set of results from the company. A change at the helm and a revamped divestments programme is aiming to create a sense of 'new beginnings' for the company, with a critical assessment of strategy, operations and assets. Within a context of a difficult operating environment in the upstream and downstream segments for all players in the industry, especially IOC peers of Shell, Shell's reliance on natural gas and a string of exploration disappointments (the most recent of which was the dry hole in GM-ES-5, the final well in an exploration campaign offshore French Guiana) have compounded the challenges the company faces.

The underperformance of its stock price relative to its peers and the wider equity market reflects the market discontent with Shell's course over the past year. We see the strategic re-focus to a more tightly controlled capital allocation and a focus on the most valuable assets as necessary in a climate of softening prices and increased competition.

Shell - Laggard Of Its Class
O&G and S&P 500 Equities, 1 January 2013 = 100

It is clear that new CEO Ben van Beurden is not looking to continue on the path set by his predecessor, Peter Voser, but instead, in his first major address as CEO his message was one of change. He outlined three priorities:

  • Improved financial performance

  • Enhanced capital efficiency: reduced capex and increased divestments

  • Delivery of new projects

Shell certainly needs a self-critical assessment of its global portfolio. Not only is its portfolio overweight on a complex segment (natural gas) which has changed drastically in the past five years (from shale in the US, to Fukushima and the East African discoveries), but its metrics show that compared to its peers it became complacent with its spending.

Return on capital employed, an area that is a core metric for van Beurden to measure the success of the company's new strategy has been declining in recent months. This has been the case with its peers, but Shell has been fairing worse than Exxon and Chevron on this metric. On price-to-book Shell's numbers show a circumspect approach by the market to the company's growth prospects.

Barely Beating BP
Price-to-Book Ratio
Diminishing Returns From Capex
Return On Capital Employed, %

The fourth quarter results not only dragged down the overall 2013 performance but also stand in stark contrast to the company's performance in 2012, highlighting a steep deterioration.

Over the fourth quarter of 2013 Shell has taken a further US$631mn impairment charge in two liquids-rich plays in North America as well as the Kulluk drilling rig in Alaska. This further compounded the issues the company has faced with its US shale acreage - in August 2013 Shell took an initial US$2.1bn impairment charge in liquids-rich shale assets in the US. The loss from North American operations reached US$1.4bn in the fourth quarter alone, compounding to US$3.4bn loss in revenues over 2013.

US Still A Drag
Earnings by Geography (Left) and Segment (Right, for FY2013), US$mn

Total revenues in 2013 fell by 5% y-o-y to US$460bn; net income by 40% to US$16.4bn reflecting the project cost inflation that Shell (along with its IOC peers) is facing.

Lower production rates, force majeure in Nigeria, high capex, few divestments and exploration disappointments have put the spotlight on the company's cash flow. Net cash from operating activities fell by 12.4% y-o-y in 2013 to US$40.4bn. On the one hand, the lower income for the fourth quarter, and on the other hand higher depreciation, amortisation and depletion provisions (US$5.6bn, +47% y-o-y) dented the company's cash flow from operating activities.

In terms of volumes produced and sold, total liquids sales were 1.5mn b/d, down from 1.6mn b/d in 2012. Nigeria was a main culprit with average daily volumes available for sale of 89,000 b/d, compared to 136,000 b/d in 2012 on the back of illegal bunkering and sabotage in the Delta. We believe that Nigeria will remain a highly risky operating environment. Not only has the Petroleum Industry Bill lost any momentum that could see it pass in the current parliamentary term, but on the security front, the increased capability and sophistication of pirates operating in West Africa has made the Gulf of Guinea the hotbed for piracy activity globally ( see 'Mounting Piracy Issue Recognised But Capacity Remains An Issue', 3 January). Following the divestment of four of its onshore licences in the Delta in 2013, we could see the strategic review of assets also include more Nigerian acreage as the opportunity costs escalate and the outlook is deteriorating.

Liquids production from Europe and Asia were also down 19% and 14% respectively to 178,000b/d and 141,000 b/d, as was production from the CIS and Russia, Latin America and Sub-Saharan Africa. Middle East and North Africa produced some gains with a rise in the average daily production of liquids of 10% to 486,000b/d. The US was the only other market that produced higher liquids volumes in 2013. Total liquids production from the US was 237,000 b/d, up from 222,000 b/d in 2012.

Shell is primarily a natural gas company as is evident by its earnings (see graph above), with more than half coming from natural gas. Total natural gas production was 1.8% higher in 2013 compared to 2012. With the exception of Nigeria and Russia, natural gas production grew across all the other geographies.

Nigeria Troubles To Persist
Shell Natural Gas Production (bcm) by Geography, and y-o-y % Change

Unlike crude oil, the volatility and costs associated with the natural gas market means that it becomes more difficult to manage during a weaker market environment.

With the acquisition of Repsol's LNG portfolio for a net of US$3.8bn, Shell's foothold in the LNG market became more established signalling that the company's future is rooted to a large extent in its LNG portfolio. In 2013 equity LNG sales totalled 26.7bcm, equivalent to 27% of Shell's global gas sales. With the addition of Repsol's volumes equity LNG sales are expected to rise to 32.4bcm, making Shell the largest private LNG owner and operator in the world by 2017 with a difference of about 14bcm to second largest Exxon. As a matter of comparison, state-owned Qatargas, the largest LNG player globally, produces and sells approximately 57bcm per year of LNG.

Putting a lot of its eggs in the LNG basket however carries significant risk, even for the trailblazer in the sector.

The Australian projects are going to be operating on narrower-than-intended margins due to a combination of huge project cost inflations, new supplies and the changing landscape in pricing LNG. The decision to divest its stake in Wheatstone LNG reduces Shell's exposure to those risks. It also raised question marks about the Arrow LNG project and to what extent it will remain as part of its portfolio, or if Shell may look to cut its stake in that project too ( see 'Sale of Wheatstone Bodes Ill For Arrow', 23 January).

Our research suggests that everything else remaining equal, over the coming years global liquefaction capacity additions will grow faster than regasification , narrowing the difference between import capacity and LNG availability.

Heading Towards A Market Equilibrium
LNG Nameplate Capacity In Operation and In Planning/Under Construction, bcm

We are therefore looking at a switch from a sellers market, to one where there is going to be a better equilibrium between the supply and demand availability. Established pricing practices are already coming apart at the seams with new sellers (US LNG) looking to gain a competitive advantage with lower prices, and big buyers (Japan, South Korea) becoming more vociferous against getting locked in expensive long term contracts. While we are still in the very early stages of an evolution in the pricing regime of the natural gas market, there is no telling how radically the market for natural gas will change over the planned life-cycle of these new mega-projects. Project economics always carry a significant amount of risk and uncertainty; however, with an average 30% cost increase across the LNG projects planned in Queensland and a changing pricing environment, the outlook is even more nebulous for some of the largest LNG projects around the world.

Weaker Returns On Tighter Margins, Queensland LNG Projects Under Construction
Project Initial Estimate, US$bn Cost To Date, US$bn Extra Drilling (included in Cost To Date)
Queensland Curtis LNG 15 22 2
Gladstone LNG 16 18.5 2.5
Australia Pacific (APLNG) 22 23.7 -
Arrow LNG 24-26 34-36* -
BMI Research

The shale gas assets in the United States have been the Achilles heel of Shell with a string of impairment charges hitting the company's net income. Divestments have reduced Shell's holdings in Niobara shale, Mississippian Lime, Utica and Eagle Ford. They have also sold their oil shale assets in Colorado. The assets in Haynesville and Marcellus do not seem to be in line for divestment. Their lack of acreage in the liquids-rich Permian or Bakken basins has put them on a disadvantage compared to Exxon in US unconventionals space as they have not been able to extract as much liquids potential from their assets, or easily switch drilling priorities from gas to oil plays.

It has certainly been a disappointment for Shell, though with Henry Hub prices rising, LNG export licences accelerating, new gas infrastructure in place, new petrochemicals ramping up demand from 2018, and natural gas firmly entrenched in the future US energy mix, there could be upside for the value of shale gas reserves.

Prices Rising In The Coming Years
BMI Henry Hub Price Forecast, US$/mn BTU

The disappointment with the US shale assets however does not mean that the company has not taken its unconventionals expertise elsewhere. While the mega-projects such as Mars B will spearhead new production for Shell in the coming months, the company has been creating a portfolio of assets in more frontier markets, including Turkey, Ukraine, Bosnia, Albania, China shale and Argentina. Without taking on too much financial risk, Shell has steadily built up a portfolio of assets (especially a string of assets in South Eastern Europe) which could unlock significant long term reserves, especially in Argentina and China:

  • In Turkey it is becoming involved in the exploration of the Dadas shale, which geologic estimates suggest could hold 100bn barrels of oil in place..

  • In Ukraine, Shell has committed to a 50-year, US$10bn unconventional gas development plan and it has reiterated its plans to begin exploratory drilling on the Yuzovskaya field this year.

  • In Bosnia, Shell is reportedly in talks with the government to revive an oil concession in the Dinaridi area of the Federation of Bosnia and Herzegovina.

  • In Albania, the discovery of light oil in the Shpirag licence area could mean a commercial discovery and a new oil play in the region.

  • In Argentina, one of the largest shale provinces outside the US, Shell has pledged to triple its investments in the Vaca Muerta in 2014 to US$500mn.

  • Last but not least, the biggest bet for Shell has been shale gas exploration in China were the company is involved in exploration in the Sichuan and the Xiang E Xi basins. While taking into account water scarcity and unique geological characteristics of shale formations in China, we have factored shale gas production in our forecast for China from 2015 onwards, with shale gas making a noticeable contribution post -2018 when annual production could be 26bcm, equivalent to 17% of total.

2018 Ramp-up In China's Shale Gas
China Conventional and Shale Gas Production Forecasts

The downstream segment will be more difficult to navigate and we believe will continue to be a drag on earnings. At best earnings from downstream will stagnate. Earnings from downstream operations in 2013 recorded a loss of US$600mn.

Asian and European margins were wafer thin, with refining margins in Singapore on average loss-making at minus USc0.95/bbl. At Rotterdam refining margins for Shell were on average US$1.40/bbl, compared with US$3.85/bbl and US$8.7/bbl in the Gulf and West coasts respectively of the US.

We believe that the divestment of their western European downstream assets is a good move as it ensures that they will make a clean break out of a market we do not see as having any prospects to grow, and is in need of consolidation and shrinking. In fact, established refining centres in Asia and Europe are facing the same challenges: new refineries in the Middle East, China and South East Asia are squeezing older generation refineries out of the market. The rise of the US as a fuels exporter is further undermining the refiners' position in Europe and north Asia, especially in the middle distillates and LPG segments.

Asia And Europe Woes
Shell - Refining Profit Margins Realised Per Region, US$/bbl

The new strategic steer of the company involves sharpening up in delivery of projects and improving returns and cash flow performance, which if successful, will also improve these metrics of efficiency and future growth as well.

The start-up of production from Olympus, the second platform on the Mars B deep-water field a few days after the new strategy announcement, and six months ahead of schedule, bodes well for the new direction. Olympus will add 100,000 boe/d to daily production by 2016, taking the total from Mars B to 160,000 boe/d at the time of full ramp-up.

There is certainly a sense of more risk aversion. The decision to drop the Gulf Coast gas-to-liquids project because the project economics looked shaky, as well as the decision to end the Alaska Arctic exploration campaign certainly underlines this approach.

Shell is planning US$15bn in divestments over 2014; an aggressive target in what is shaping up to be a buyers' market considering that in Q4 divestments were a mere US$300mn. The ball already started rolling with the divestment of a 23% stake in the field BC-10 in Brazil and the divestment of its 8% equity in the in the Wheatstone-Iago gas fields and its associated 6.4% stake in the Wheatstone liquefied natural gas (LNG) project. Qatar Petroleum bought the BC-10 stake, while Kuwait Foreign Petroleum Exploration bought the stake in Wheatstone. There are no other specifics on what may be getting sold though we reiterate that the Arrow LNG project could come under intense scrutiny as it is still pre-FID and already 40% above initial cost estimates. On the downstream sector, Shell will book the proceeds from the sale of its 16.3% stake in Ceska Rafinerska in early 2014, and will continue with assets sales over the year. Western European assets in Germany, Norway and Italy will be at the forefront of assessment.

Capex in 2014 is going to reach US$37bn, in line with what ExxonMobil is looking to spend and slightly less than Chevron's US$40bn.

Given that Shell is going to focus on delivering integrated gas and deepwater projects, the company is opening itself up to a significant risk of cost overruns and delayed project starts as learning curves remain steep for some of these mega-projects. The delays and disappointments with the start-up of Kashagan in Kazakhstan are a case in point, though probably the most severe of project delays the company will have to face, but considering the challenging projects it has taken on, may not be the last ones.

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