3 Threats to Royal Dutch Shell's Success

Investors in Royal Dutch Shell (NYSE: RDS-A  ) are more than likely starting to get a little frustrated with the company's poor performance. Over the past three years, Shell has had a total return of only 17.5% while the S&P 500 has produced a total return of over 55% during that time frame. To make matters worse, the company has decided to scrap its production targets because it would not be able to make a decent enough return on those targets. 

Shell has a lot of work to do in order to turn the ship around, but there are few obstacles in its way that could make it even more difficult. Let's take a look at three of those threats that could further impact the woes of Shell.

Getting Nasty in Nigeria
Shell has been operating in Nigeria for over half a century, and it has been one of the core production regions for the company for many years. In the past few years, though, Shell's operations in Nigeria have become more and more tenuous. Between 2010 and 2012, Nigerian production has dropped over 20%, and this is expected to continue for a while as the company deals with several instances of theft and sabotage. Shell estimates that this year alone the company will spend $12 billion on issues surrounding theft, sabotage, and an embargo at its LNG facility there.

Of course, Shell isn't alone with issues in Nigeria. Both Total (NYSE: TOT  ) and Chevron (NYSE: CVX  ) have both gone on record about the frustrations regarding these issues as well as the Nigerian National oil companies insistence to have greater control of domestic production. All three of these companies have announced that they will be focusing more on the offshore regions of Nigeria and unwind their onshore assets because they are less likely to suffer from theft and sabotage. 

Of all these companies, though, Shell is the largest player in Nigeria and it is still responsible for over 16% of the companies oil production. If the company wishes to maintain a strong oil position, it will either need to focus on making its operations there more secure or concentrate on moving out of the region. 

Declining, Expensive Reserves
Over the past few years, Shell has struggled to maintain a reserve base. Between 2011 and 2012, the company's proved, probable, and possible reserves dropped by 5%. Some of that drop may not be completely the fault of the company because proved reserve estimates are tied to the price of that commodity. So the big drop in natural gas prices last year, especially in the US, will show up on the balance sheet but may not be a major threat in the long term. 

At the same time, though, Shell's exploration plans have not gone as it hoped. The company has recently shelved its exploration plans in the Chuckchi and Beaufort Seas after a drillship ran aground. The grounding was more like an insult to injury, though, because Shell has spent $5 billion exploring this region with nothing to really show for it. 

It's no surprise that finding oil is becoming more and more expensive, but Shell really stands out as one that is paying a high price to replace its reserves. In an Ernst & Young study of reserve replacement costs for 50 exploration and production companies, both Shell and BP (NYSE: BP  ) ranked in the bottom 5 with reserve replacement costs of $41.76 and $72.03 a barrel, respectively. In that survey, the average E&P company was spending $19.44 to replace a barrel of oil. 

Somber Shale Production
Just like every other shale producer in the US, Shell took some major hits from low natural gas prices in 2012. Unlike many others, though, it hasn't been able to recover since then. This past quarter was another disappointment for Shell as it took a $2 billion write down on its liquids rich shale assets. Furthermore, the company has announced that it will sell its holdings in both the Eagle Ford and the Mississippian Lime formations because it has struggled so mightily on its shale assets.

For many of the players in big oil, this has been the norm rather than the exception. Exxonmobil (NYSE: XOM  ) has seen its return on capital employed in its upstream US operations drop to a paltry 6% thanks in large part from disappointing results from its acquisition of XTO Energy. The problem that many of these major players are finding is that their assets are not in the prime locations in these shale formations and the economics are not attractive.

Even not including the sales mentioned above, Shell still has major shale assets across the US. If the company hopes to turn things around, it will need to focus on how it can generate a greater return on its assets. Increasing natural gas and domestic oil prices should make these assets slightly more attractive, but the company could benefit from improving operational efficiencies as well.

What a Fool Believes
Turning the prospects around at Shell will be a daunting challenge for its new CEO Ben van Beurden when he takes the helm of the company next year. The company has carved out a very attractive niche in the LNG game, but the question still remains if the economics on all of these projects will remain attractive as costs continue to run out of control and other regions of the world start to unlock shale gas. For investors who may be considering Shell right now, it may be wise to hold off, but if it can address the issues above then it may be worth reconsidering down the road. 

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