Royal Dutch Shell (RDS.A, RDS.B) is going to have a rough time for a while. This quarter’s results are a warning of what is to come. Nevertheless, the company’s integrated gas segment stands to benefit from quicker switching to gas. The dividend cut takes away a lot of the investment case from the stock, but Shell’s long-term prospects still look promising. Though there is downside from here, Shell’s oil-light investment strategy looks like it may be validated sooner than expected.
Shell’s first-quarter results were underwhelming at best. The company’s free cash flow increased substantially, to $12.133 billion from $4 billion a year ago. This sounds impressive at face value, but is primarily due to a massive decrease in working capital.
(Source: Shell’s Q1 report)
This is unlikely to happen again in another quarter, and without this adjustment in working capital, Shell’s cash flow decreased significantly, as it likely will next quarter. The company’s EPS was $0.00 per share, with a net loss of $23 million for the quarter. Overall, this was a rough quarter, but it will likely only get worse from here, since for a significant portion of Q1, oil was still at a profitable level.
Integrated Natural Gas Is Its Strength
Shell, as the world’s largest non-state-owned natural gas producer, has decent exposure outside of oil through this segment. By the same token, natural gas is often hedged and tied with oil prices, which can drag the prices down at a time like this. Fortunately, this has an upside. With natural gas prices in East Asia now roughly equivalent to coal, the transition to gas is expected to be sped up considerably.
Looking to fill this demand, Shell has decided to go ahead with its investment in the Surat Gas project in Queensland to produce 90 billion cubic feet of gas per year at peak. The company also decided to bow out of the Lake Charles, Canada project with Energy Transfer (ET), likely because the distance to reach more attractive markets is more expensive and unattractive under current financial stresses.
As CEO van Beurden said:
Our Integrated Gas and Marketing businesses continued to achieve robust results this quarter, bringing resilience to our cash flows.
The volatility in oil prices has an effect on natural gas as well, but with natural gas’ usage continuing to expand, the opposite of which is true for oil. Natural gas will benefit in the long term from this oil crash. Shell’s production increased by 12% for the first quarter as new production came on-line.
These are extraordinary times. When I said a month ago that I thought it was unlikely – though not impossible – that Shell would cut its dividend, never did I think we would see an oil market like this.
Given the fact of, brief, negative front-month oil prices, it is clear that we are now in a much different oil market than even a month ago. Oil has since rebounded some, and as I write this, prices have recovered to $17.60/bbl. With oil prices well below the breakeven point for Shell, a dividend cut seems wise. The dividend was slashed by two-thirds to 32 cents per quarter on ADS shares.
Though I think that a dividend cut removes a significant portion of the reason to invest in Shell, the company should have more financial flexibility to weather this crisis. Its forward yield of 3.79% isn’t a terrible yield, but well below what we expect from an oil supermajor. If you are looking for an income investment, it may be time to look elsewhere.
Why I Still Like Shell
Shell has already been moving away from oil investment and towards electricity production through renewables, along with natural gas. Though some people point to Shell’s below-average oil reserves and see that as a reason for alarm, given the new oil environment, I see that as less of a liability rather than a benefit.
Natural gas demand is expected to continue to grow in the coming years, which will help Shell’s recovery. This oil shock also supports the case for Shell’s efforts to transition itself into, essentially, an enormous utility company. Something that, if well-executed, I am in favour of. I know this is a divisive issue, but oil demand continues to be under pressure, and this crisis may speed the adoption of alternative energies, which Shell has been pursuing.
On the oil front, a record number of small companies have been shuttering production, along with OPEC cuts equal to around 13% of global production. Combined with the inevitable re-opening of the global economy, oil prices can be expected to rebound, even if not to levels previously reached. This will help to lift Shell’s stock when it happens.
I trust Shell’s management, and I appreciate the honesty with which they have portrayed the impact of the coronavirus and oil collapse. The company’s shares are not at a place now which I think reflects the reality of our situation. As Shell’s CEO said, “It’s hard to say if oil demand will ever return to levels seen in 2019.” Once a full quarter with this oil pricing has been reported, I see further downside for the company’s shares, and for this reason, I cannot recommend buying shares at these levels. In the long term, Shell will endure and remains an attractive company, but there will be significant pain along the way.
Note on Figures: Unless otherwise cited, all figures are from Shell’s first-quarter earnings report.
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Disclosure: I am/we are long RDS.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and should not be regarded as investment advice. This article should not be the sole basis for a financial decision, including the purchase or sale of stock. Any personal financial decision should be made on the basis of your own research and consideration of your unique financial goals and investing ideals.