How Serious Is Shell's Profit Warning?

Shell’s recently issued profit warning highlights some of the company’s biggest challenges in the years ahead.

Jan 19, 2014 at 12:00PM

On Friday, Royal Dutch Shell (NYSE:RDS-A) issued its first profit warning since 2004, saying that its fourth-quarter results will come in below expectations because of a combination of higher exploration expenses, lower production volumes, and continued weakness in its refining division.

Is this just a temporary setback, or could it be a sign of a potentially bleak future for the company?

Shell's profit warning
Less than three weeks after Ben van Beurden took over from outgoing CEO Peter Voser, Shell announced that it expects its fourth-quarter earnings on a current-cost-of-supplies basis excluding identified items to come in at $2.9 billion, down nearly 50% from a year earlier.

The company expects upstream earnings to be negatively affected by a high level of maintenance activity during the fourth quarter, especially in the North Sea and Gulf of Mexico, which reduced oil and gas production volumes, as well as LNG sales volumes.

Continued weakness in the company's loss-making North American upstream business, challenging security conditions at its Nigeria operations, and a weaker local currency in Australia, where Shell has various LNG projects under construction, are also expected to weigh on fourth-quarter earnings.

While the company's profit warning is certainly overwhelming, some analysts argue that Shell may simply be dishing out all the bad news it has ahead of its earnings release, choosing to lower expectations now instead of disappointing the markets with its quarterly statement. Whether or not that's the case, Shell's warning highlights a number of key challenges in coming years.

Shell's spending and capital efficiency issues
At the heart of the debate about Shell's future is whether or not the company can curtail its high level of spending, which came in $5 billion higher than expected last year, while improving capital efficiency. Over the years, the company has invested heavily in projects that have failed to generate sufficient returns, with its North American upstream business and its ventures in Alaska's Arctic sea standing out as two of the most prominent examples.

As a result, Shell's return on capital has significantly lagged its peers. Over the five-year period from 2008 to 2012, its return on total capital employed -- one of the best and most widely used measures of how effectively a company deploys its available capital -- came in at just under 15%. Meanwhile, ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX) delivered five-year returns on average capital employed of nearly 25%  and around 19%, respectively. Only BP (NYSE:BP), with a five-year ROCE of just over 10%, performed worse than Shell on the basis of this metric.

How Shell can improve
To improve its return on capital in the years ahead, Shell will need to drastically improve its upstream execution, which means being smarter about which projects it chooses to invest in. To be sure, the company appears to be moving in this direction, recently deciding to scrap plans for a $20 billion gas-to-liquids plant in Louisiana and divesting some of its poor performing assets, including roughly 600,000 acres in Kansas' Mississippi Lime play, 106,000 acres in Texas' Eagle Ford shale, and oil blocks in Nigeria's sabotage-prone eastern Niger Delta region.

To help keep its capex spending within its operating cash flow, the company expects to divest up to $15 billion worth of additional non-core assets in 2014 and 2015. This should allow it to keep capex spending at roughly $130 billion over the period 2012-2015, while a number of high-margin oil projects slated to come online shortly should boost operating cash flow to $175 billion to $200 billion over the same period.

The bottom line
Shell's recent decisions to sell loss-making properties and hold back on an expensive project with uncertain returns suggest that the company is serious about focusing capital only on its most lucrative, cash-generative opportunities.

But even though the company has promised to focus on achieving capital efficiency in the years ahead, true change will probably be slow, as some of the factors that have hurt the company's financial performance, such as the weak margin environment at its European refineries, are likely to persist.

As such, anybody thinking about investing in Shell should do so for the long haul and understand that it could take several years for the company to bring capital efficiency in line with peers and materially improve its financial performance.

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Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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