Why Shell Scrapped its U.S. Gas-to-Liquids Plant

Royal Dutch Shell (NYSE: RDS-A  ) announced recently it would abandon plans for a massive plant in Louisiana that would have converted natural gas into higher-value distillates such as diesel and jet fuel. Let's take a closer look at what factors shaped the company's decision and whether it is a good one.

Cost concerns
Though Shell has a great deal of expertise with gas-to-liquids technology and operates the world's largest GTL plant in Qatar, the Louisiana project was expected to cost more than $20 billion, up from an initial estimate of $12.5 billion. That is a price tag Shell can ill afford during a time when its capital budget has come under increased scrutiny.

Investors have put renewed pressure on the company to reduce capital spending, which is expected to come in at a record $45 billion this year, roughly $5 billion higher than the company's previous guidance. With total capital spending for 2012 and 2013 expected to reach $75 billion, the company will likely have to resort to asset sales of roughly $15 billion if it is to meet its target of $130 billion in spending over the 2012-2015 period .

Meanwhile, Shell's peers are planning to either boost capital spending modestly or reduce it. For instance, ExxonMobil (NYSE: XOM  ) expects its capital spending to rise by just $1 billion annually over the next five years, while Chevron (NYSE: CVX  ) projects 2014 spending in the range of $33 billion-$36 billion, compared to an expected $36.7 billion this year. Meanwhile, Total (NYSE: TOT  ) plans to reducing capital spending to $24 billion-$25 billion over the 2015-2017 period, down from an expected $28 billion-$29 billion this year.

Long-term project economics uncertainties
Another major reason Shell decided to hold back on the project is uncertainty over longer-term oil and gas price differentials. Gas-to-liquids projects operate by converting gas into higher-valued petroleum distillates, such as diesel, naphtha, and lubricant base oils, through a chemical process that synthesizes carbon monoxide and hydrogen into synthetic fuels.

In order for GTL plants to be profitable over a long period of time, natural gas prices have to stay low relative to diesel and jet fuel prices. While this is currently the case, there's too much uncertainty as to whether the situation will continue over the next several years, especially since LNG exports and other demand drivers are expected to boost the price of natural gas, while surging U.S. shale production is putting downward pressure on crude oil prices.

With Shell's decision to scrap its Louisiana GTL plant, South Africa's Sasol (NYSE: SSL  ) is now the only company planning to build a commercial GTL plant in the U.S. The Johannesburg-based company announced last December that it would construct a facility in Louisiana at a cost of $11 billion-$14 billion, with production expected to begin in 2018.

Did Shell make the right move?
In my view, Shell's decision to scrap its proposed GTL plant in Louisiana mainly reflects the company's renewed emphasis on capital discipline and will likely prove to be a good one. While there's nothing wrong with pursuing GTL technology per se, Shell has better avenues to which it can allocate capital, including high-margin oil projects such as Mars B and Cardamom in the Gulf of Mexico and Gumusut-Kakap off the coast of Malaysia, as well as numerous LNG projects around the world.

These projects are more likely to help the company meet its near-term goal of boosting cash flows to fund its ambitious capital spending program, with the high-margin oil projects providing more immediate cash flows and the LNG projects providing strong and stable cash flows for decades to come, owing to their flat production profiles.

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