A New Direction for Royal Dutch Shell

With a new CEO at the helm, cost reduction and capital efficiency will be the name of the game for Royal Dutch Shell.

Feb 8, 2014 at 12:00PM

Though Royal Dutch Shell's (NYSE:RDS-A) financial performance over the past few years has been quite disappointing, the company is eager to turn things around under the guidance of its new CEO, Ben van Beurden.

Targeting asset sales to the tune of $15 billion this year and next, Shell aims to significantly reduce its spending over the next few years. Will it be enough to boost cash flow and sustain its hefty dividend?

Shell's new direction
Over the past few years, Shell spent aggressively on megaprojects around the world in a desperate bid to boost its oil and gas production. But, recognizing the issues inherent with boosting output in a world where the costs of finding and developing new reserves have risen exponentially, the company has changed its game plan.

Speaking to investors last week, van Beurden outlined the company's new focus on cost reduction, reaffirming plans to accelerate the company's pace of divestments over the next two years. He also announced that executive compensation will now be partially tied to the company's returns on capital, which is encouraging.

Reflecting his hard stance on improving Shell's financial performance, van Beurden said he planned to carefully review all of the company's different businesses. Those deemed uncompetitive in terms of the returns they are expected to generate relative to their costs will be candidates for sale, he said.

"We haven't always made the right capital choices," he admitted. He identified Shell's North American shale gas and oil business and its global oil refining business as the two biggest businesses that will be restructured in coming years. This year, the company plans to reduce its capital spending to about $37 billion, down from a record $46 billion last year.

Capital efficiency needs to improve
But Shell's real problem isn't the level of its capital spending. Rather, it's the wholly unsatisfactory returns generated by that capital spending. Poorly timed investments in U.S. shale properties, continued disruptions to its operations in Nigeria, and a disastrous drilling campaign in Alaska's Chukchi sea are three of the best-known examples of the company's poor capital allocation decisions.

As a result, Shell has sorely lagged its peers in terms of return on capital employed -- one of the best measures of how effectively a company deploys its available capital. In the five years from 2008 to 2012, its return on capital employed averaged under 15%, compared with nearly 25% and just under 20%, respectively, for peers ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX). Only BP (NYSE:BP), which had a five-year ROCE of just over 10%, proved to be a worse capital allocator than Shell over the period.

To Shell's credit, though, it does appear to be serious about improving its return on capital judging by recent decisions. It has already put up for sale poor-performing U.S. shale properties, as well as oil blocks in the troubled Niger Delta region. It also announced that it would scrap an expensive $20 billion gas-to-liquids project in Louisiana and will hold back on drilling in the Alaskan Arctic this year.

The bottom line
With its departure from loss-making North American shale plays, an ongoing restructuring of its chronically underperforming refining business, and asset sales this year and in 2015 set to bring in $15 billion, Shell is zeroing in on high-margin oil projects and LNG projects to boost cash flow.

If the company can manage to keep its spending at around $35 billion a year while generating roughly $45 billion in annual cash flow, it should be able to sustain its hefty dividend. Indeed, Shell's recent decision to increase its dividend by 4% certainly seems to suggest confidence in its ability to grow free cash flow over the years. It will be interesting to see if the company can deliver on its promise.

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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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