Reports

Royal Dutch Shell: More Than Just Oil And Gas

Published on : 2020-10-17

Source: Shell Investor Relation

Investment thesis

There is always a lively debate in the comment section of articles about Royal Dutch Shell (RDS.B) (RDS.A). People are usually divided into two camps. One represents those that think RDS should stick to producing and selling as much oil and gas as they possibly can, and certainly not waste shareholders’ funds on new forms of green energy.

The other camp, a minority if I may say so, is positive about the reshaping of RDS that is taking place. The polarization is akin to what we see in the political debate around the world. There is little middle ground. You are either for or against it.

With this article, I hope to convince some that the action RDS is taking is the right thing to do.


How important is oil and gas production to RDS?

A good place to start is defining how much of RDS’s revenues and net profit comes from the exploration and production of oil and gas. At least then we know how important this debate really is.

Source: Data from 2nd Quarter 2020 results. Compilation by author.

As we can see, the bulk of the cash flow still comes from the production of oil and gas.

During the management recent guide for the 3rd Quarter, they informed that they do expect oil production to be between 2,150 and 2,250 thousand barrels of oil barrel equivalent/day. This is much lower when we compare it to the same period one year ago. They then produced 3,563 thousand obe/day.

This leads us to the ongoing debate about RDS’s oil reserves.

Source: Data from RDS Investor website

There are two very important aspects we need to consider when we debate the reduction in the reserves.

First, and foremost, is the technological advancement taking place in the drilling space. Bear in mind that when you think that a well is empty, it is obviously not completely empty. There is always going to be oil and gas left in the well. Oil companies stop producing from a well when they think that it is economically not feasible to continue. RDS has communicated that they intend to cut the cost of production of its oil and gas by 40%

Some of these reductions in costs come from improvements in operational efficiency.

Secondly, we do need to ask ourselves the question of what source of energy, and how much of it, will be required 10 or 20 years down the road. If it turns out that “peak oil” in fact one day does occur, would you want to hold a huge and expensive inventory of this commodity in the ground?

These are the questions that all oil majors are grappling with on a daily basis. I am sure it is front and center in RDS’s discussions too.

I might be naive, but I recognize that RDS with all their expertise surely knows better than me with my limited knowledge on these very important topics. I trust that they will make the right decisions on what is best for its shareholders.


RDS in 2030

It is not just the consumer who decides what kind of energy sources they will be using in the future. At the end of the day, it will be the international and national regulators which have by far the biggest task in deciding what kind of energy source you and I will be using to transport ourselves, and how industries are going to produce whatever they produce.

Fellow author, Power Hedge, has just published an interesting article on Total (TOT) titled “ Going Green Creates Opportunity”. They are of the opinion that they will be selling 30% less oil by 2030.

RDS must be thinking along the same lines. It would be foolish of shareholders, and reckless of the company’s management, to think that we can just keep things at status quo.

One way to gauge how RDS will look like ten years down the road is to look at what assets they are selling, and where they are investing more capital.

Many of these assets have been with RDS for many years. To illustrate this, I would like to share with you about RDS here in Singapore. There is a small island not far outside the downtown Singapore business district which is called Bukom Island.

Source: Shell Investor Relation

Bukom is the largest wholly-owned RDS refinery globally with a crude distillation capacity of 500,000 barrels per day. It is also home to a large chemical plant there producing ethylene. RDS started the refinery there 59 years ago.

On the topic of refineries, in RDS’s guidance to third Quarter 2020 results, Mr Van Beurden talked about streamlining their assets. In 2005 RDS had as many as 55 refineries around the world. They currently own and operate 17 refineries, with concrete plans to reduce this to less than 10 sites.

If they thought that the future of RDS lies in refining crude oil in so many countries, why are they selling off so many of the refineries?

I do understand that all industries consolidate and optimize their footprint. However, it is clear to me that RDS does not want to be stuck with lots of oil and gas assets decades later as and when there will be less demand for them. To me, that is a clever move and should be applauded.

Just because they are divesting of some assets, it does not mean that they are not investing for the future. This year Capex is estimated to be around $20 billion, so they are clearly still investing.

Even in traditional businesses such as chemical manufacturing.

In May RDS and China's CNOOC (NYSE: CEO) agreed to invest a further USD5.6 billion to expand the ethylene project in Huizhou, located in Guangdong province in China. It will add another 1.5 million tons per year production capacity to the already 2.2 million tons it produces now.

Source: Google map

This joint venture has developed into one of the largest and most cost-competitive petrochemical facility in China, and the world.

They have also started constructing a polycarbonate development unit at its Jurong Island chemical plant in Singapore. Polycarbonate is a transparent and impact-resistant engineering polymer. It is used to make vehicle headlights, LED spotlights, UV-blocking windows, and spectacle lenses. The development unit will enable Shell to improve the technology used to produce polycarbonate when combined with its own patented technology

To get an even more in-depth idea of how RDS see themselves going forward, it is recommended that you read their presentation slides from their Responsible Investing Annual Briefing, which took place on the 16th of April this year.

Source: RDS Responsible Investing Annual Briefing


Value-adding

As I have pointed out in earlier comments, oil and gas are one of the two most tradable commodities in the world. The other is iron ore. The supply of oil and gas is plentiful. It can be bought 24 hours, nearly 365 days a year, and transported to wherever it is needed. It has plenty of suppliers.

That is why value-adding is so important

RDS’s Trading and Supply division are one of the largest energy trading operations in the world. With a presence in London, Houston, Singapore, Dubai and Rotterdam they trade crude oil, natural gas, LNG, electricity, refined products, chemical feedstocks and environmental products. In addition, they also have a large shipping department.

One product the world will continue to require, no matter what kind of energy that propels vehicles are asphalt, or bitumen, as the oil companies call it. RDS is one of the world’s leaders in this field too. They supply customers across 52 markets and provides enough bitumen to resurface 500 kilometres of road lanes every day.

Then there is the number of retail outlets RDS has got.

The last time they counted it was 45,000 service stations operating in close to 80 countries. According to RDS, that is more sites than McDonalds, Zara, Carrefour, Starbucks and GAP put together. Every day, more than 30 million customers visit these sites to buy fuel, convenience items including beverages and fresh food, and services, such as lubricant changes and car washes

Tell me – if this is not “value adding”.


New Technologies and Industrial Solutions

Carbon capture and storage is a fairly new field where companies such as RDS can leverage on their expertise.

Source: Shell Investor Relation

They do operate a Carbon Capturing and Storing project at their oil sand site located in Alberta, Canada. It captured and safely stored more than 1.1 million tonnes of CO2 in 2019.

We do not have granular data on the economics of this project. However, during its construction period, it was reported to cost about $811 million to build, back in 2015. The operating costs were reported to be $41 million per year, with an estimated revenue of $27 million per year from the sale of carbon credits plus some governmental funding.

Another leader in this field is Equinor (EQNR), the Norwegian state-controlled energy company. They know that Norway will run out of oil in the not too distant future. Gas will last longer, but they are very proactive in R&D and exploring how they can utilize whatever competency they have built up to become relevant in the future. Through extensive R&D they will also find new areas that can be explored profitably to benefit all stakeholders, including their shareholders.

With the full support of the Norwegian government, EQNR has taken a leadership role in carbon capturing and storing.


Why is it important to send the CO2 back into the ground where it came from?

Carbon capture is absolutely a necessity. There’s no way to get close (to goals set by the Paris Agreement) without carbon capture because gas will continue as an important, major part of the energy mix. - Daniel Yergin

Currently, there are 18 major CCS projects around the world, but according to Internation Energy Agency, we will need to capture and store more than 6 billion tons of CO2 every year in order to reach UN climate goals.

EQNR has been involved in Carbon Capturing and Storage for more than 20 years. They store the CO2 at two offshore fields (Sleipner and Snoehvit) equals to the annual emission of 10 million cars.

The Northern Lights project, which is a collaboration between EQNR, TOT and RDS is a full-scale project which captures CO2 from industrial capture sources (cement and waste-to-energy) which is liquified in the Oslo-fjord and shipped to an onshore terminal on the west coast, where it is piped out to and offshore storage location subsea in the North Sea for permanent storage.

I expect, and hope, readers will come back and ask me who is going to pay for this?

It’s a good question. I honestly do not have all the answers. However, I do believe that the initiative will come from governments. Any action that has to be taken towards cleaning up the environment must be led by lawmakers and regulators. Up to this date, they have been quite good at taxing the consumers for their usage of gasoline.

Some carbon tax will surely become universal. Those that produce the CO2 will have to pay to dispose of it. And it is likely going to be the same people, like RDS, which will charge people to pump the carbon back after pumping it up.


Return on investment

In recent guidance, Van Beurden did point out that the return from these renewable energy projects are not the same as what they have been used to in the past. The profit margins they have been used to in the past might just be that. The past.

However, I do think the company should be more transparent and communicate what kind of return on investment they are achieving on these new projects. I understand that there is competition involved when they bid on most of these projects and that RDS might be reluctant to show their hand, but I would say that after the ink has dried and the deals are done, it would be good if shareholder and prospective investors could be informed of how attractive the investments are.

This way, whenever we read their quarterly and annual reports, we can see if this business actually contributes or subtract from the bottom line.

All the nay-sayers' argument is that green energy is not profitable.

This is not true.

EQNR made a cool one billion dollar profit on selling one offshore wind park outside New York to BP this September.

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