Royal Dutch Shell: A Matter of Returns

RD announced its year-end results and made an extensive investor presentation in London. It's relatively easy to see why its valuation is lower than many of its peers, and why its shares carry a Hold recommendation versus a Buy for some of its peers. RD's returns on average capital employed peaked at about 20% around 2005 (hard to read from a graph) but sunk to around 3% in 2009. Contrast this with the high and persistent returns on capital earned by Exxon Mobil, and for me it explains a lot.

What underlies this difference is too much for a brief post, but here are some interesting takeaways. RD forecasts crude oil prices in a band of $50-$90/bbl through 2030. Current producing fields show declining output over this time horizon. Meanwhile, production of natural gas liquids (NGL's) increases, and gas continue to be a big source of production and target for exploration, including some interesting possibilities offshore Australia.

Refining capacity continues to be in oversupply, to the extent of 1 mmbd. Operating margins have sunk to about 2%. Capacity will be rationalized and the average size of refinery will increase over the planning horizon.

The dividend will be maintained at the prior year rate for 2010, and the company seems to be looking for creative ways to grow the payout, e.g. making it somewhat performance-related. Capital spending will be relatively constant at a high rate, and the gearing ratio may increase from its current level of 34% debt/capital. All-in-all, a riskier profile than some of its peers, arguing for a lower relative PE.

A positive takeaway is the fact that RD's exploration activities resulted in a 266% reserve replacement to production for 2009. However, in some ways, the portfolio looks like it's supporting too many diverse activities and it should be pruned over the medium term horizon.

RD has been a pioneer in unconventional resources such as the Athabasca tar sands heavy oil project. Most recently, it announced a joint venture with Cosan of Brazil, which is expected to produce 35 K boed when it is up and running. Shell gets a strong retail presence in Brazil plus a number one status in the sugarcane based biofuel market. Beyond that, a partnership with Iogen gives it exposure to cellulosic ethanol technology, but Iogen has been progressing relatively slowly relative to the hype from four or five years ago. Strategically, a company has to choose where it plants its flag in biofuels and unconventional resources, and RD has chosen sugarcane based ethanol and biomass as opposed to wind. In the medium term, it's probably not a bad choice, but this investment won't move the corporate needle.