Royal Dutch Shell (NYSE:RDS-B), one of the largest independent oil and gas companies in the world, has not been performing up to expectations over the past two years. Not only has the company embarked on major capital expenditures and acquisitions, earnings at the same time have also been falling due to downtime, heavy depreciation, and exploration expenses. However, the next two years are looking promising for the company as new projects come online and the company grows its cash flows while keeping its spending under control.
The company recently retired all of its previous financial targets. However, this wasn't surprising keeping in mind the start-up issues of Kashagan, ongoing disruptions in Nigeria, and the weak refining and gas price environment. The company is now shifting its focus from functional performance and expanding its asset base to returns and cash flows targets. Going forward, the company will measure its future performance on the basis of return on capital employed. The group has set three main priorities to increase shareholder value: 1) increased focus on financial performance, including restructuring of some of its operations (restructuring efforts are focused on oil products and North America); 2) continue to deliver growth through strong new projects (integrated gas and deepwater are growth priorities); and 3) focus on enhancing its capital efficiency.
Improving free cash flows
Shell has reached a point in its lifecycle where the company can significantly grow its cash flows from operations and at the same time slow down growth in its capital spending, which should help the company improve its free cash flows. The company is expected to deliver one of the highest cash flow growths in 2014-15 among its peers.
Shell is expected to generate $10 billion of cash flows and 200+ bps improvements in returns by 2015-16. The growth in cash flows is chiefly due to the new management focus on cost-effective operations yielding higher returns, a decrease of approximately 8% in organic capex, and a series of new high-margin projects starting in 2014. Some of the new projects, which should help the company grow its cash flows, include the Mars B project in the Gulf of Mexico, Gumusut-Kakap in Malaysia, and the newly acquired Repsol LNG assets. Repsol LNG alone is expected to generate around $1 billion in cash flows. Even if some of the projects, including Kashagan, are delayed, the high margins from the Gulf of Mexico and long life assets such as Prelude floating LNG and Stones should be able to drive growth in cash flows. The cash flow contribution from resources and downstream activities is also expected to improve.
Becoming a more dynamic asset manager
The oil sector as a whole -- and majors in particular -- has been making huge capital investments in recent years; however, in a drive toward capital efficiency the companies are cutting back their capital expenditures now. Shell, similar to its peers, has decreased its organic capex by 8% Y/Y. The company will spend $35 billion of organic capex in 2014 or $37 billion including announced acquisitions of $2 billion. Moreover, by 2015 the company is also planning to divest assets of around $15 billion ($4.5 already announced) in both upstream and downstream business, hence further strengthening liquidity. The company intends to reduce its capital spending by ~20% in the U.S. upstream business operations. The primary reductions will be in deepwater (with the completion of Mars B), the mature upstream business, and the U.S. resources business.
Setting an organic capital ceiling of $35 billion should now act as a trigger to drive harder choices from an option-rich portfolio. However, harder choices are not necessarily a bad thing for Shell. It means that rather than being a custodian the company is likely to be a more dynamic asset manager. The ceiling should also create a more focused approach and help improve project execution as it requires open discussion on projects at an earlier stage. As the decision making moves up the chain of command at a much earlier stage it should create a more efficient and focused approach at the overall group level.
I'm bullish on Shell. The company has changed its focus from portfolio enhancement to increasing its returns through portfolio upgrading and cost-efficient operations. A performance unit approach with greater accountability should help the company deliver on its internal targets. Shell has not always been a much disciplined company as far as capital allocation is concerned and has been slow to refresh and restructure its portfolio. However, the important thing is the company seems to have admitted it now and is taking measures to fix its portfolio.
Jan-e- Alam has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.