Royal Dutch Shell plc Wasn't Kidding About Cutting Costs. But Will It Pay Off?

In an effort to improve its financial performance and boost shareholder returns, Royal Dutch Shell plc (RDS.A) has pledged to drastically reduce its capital spending and divest some $15 billion worth of assets this year and next.

As part of its new strategy, the company is actively restructuring its two worst performing businesses -- downstream and North American shale -- and focusing its capital only on its highest-value opportunities. By being more selective with its spending and selling off underperforming assets, the Anglo-Dutch oil major hopes to improve its capital efficiency, boost cash flows, and return more cash to shareholders. Will it pay off?

Shell postpones Norway gas project
The most recent sign that Shell is serious about cutting costs and improving its capital efficiency comes from its decision last week to postpone a major offshore natural gas project in Norway because of rising costs and uncertainties over the project's resource potential.

That project is Ormen Lange, Norway's second-largest gas field, where Shell had planned to use a massive compressor located on the seabed to boost gas recovery. But according to a statement posted on Shell's website on Friday, the partnership developing Ormen Lange -- a consortium that includes Shell, Statoil (EQNR -0.07%), Dong Energy A/S, ExxonMobil (XOM 0.02%) and Petoro AS -- has decided to delay the project.

The decision was based on new data suggesting the field may contain less recoverable gas than initially believed and would cost more to develop than previously expected. Based on this updated assessment of capital costs and expected production, Odin Estensen, chairman of the Ormen Lange Management Committee, determined that the project would not currently provide a sufficient rate of return.

Estensen's comments highlight one of the biggest challenges facing large integrated oil companies like Shell -- that of growing oil and gas production in an environment of rising costs and stagnant commodity prices. Amid pressure from shareholders, most oil majors have pledged to cut capital spending and focus on delivering stronger returns for their investors.

A more disciplined Shell
Shell is a shining example. The company recently sold off key downstream assets in Australia, including a major oil refinery and network of some 870 retail gasoline stations, due to weak margins. It also put up for sale numerous North American shale assets last year, including acreage in Texas' Eagle Ford shale and Kansas' Mississippi Lime play, because of disappointing drilling results and poor expected returns.

Shell has also scrapped plans to construct a massive facility in Louisiana that would have converted natural gas into higher-value liquids because of the project's high expected costs and uncertainty over long-term price differentials. Lastly, it is also currently marketing oil-producing properties and oil infrastructure in Nigeria, where persistent theft and sabotage continue to plague its operations.

These developments point to a company that is becoming much more selective with how it spends its money -- a far cry from prior years when it binged on expensive projects with uncertain returns such as its drilling program in Alaska's Chukchi sea. This year, Shell expects to reduce its capital spending by about $9 billion as compared with last year.

Will it pay off?
By cutting spending on lower-margin, higher-risk projects and focusing on its most lucrative opportunities, Shell should be able to improve its return on capital employed, or ROCE -- a crucial measure of how effectively it deploys available capital -- over time. The company's ROCE has been quite poor, averaging just under 15% over the five-year period from 2008 to 2012.

By comparison, peers ExxonMobil and Chevron have done a much better job of allocating their capital, with Exxon generating a five-year average ROCE of nearly 25% and Chevron's coming in at just under 20%. If Shell can gradually improve its ROCE and keep capital spending at around $35 billion per year, the combination of $15 billion worth of asset disposals and stronger cash flows from new high-margin oil projects start-ups should drive stronger cash flows in the years ahead.

However, this outlook hinges on a couple of key factors -- Shell's ability to complete projects on time and on having budget and commodity prices remain high. Any unexpected shortfalls in production or a sustained decline in oil and gas prices could significantly affect the company's expected cash flows and hinder dividend growth. All told, while Shell has made commendable progress in enforcing capital discipline, investors should seriously consider these risk factors before investing in the company.