Shell Pearl GTL, Qatar. Source: Shell Flickr account.
It goes without saying that this past year has been a rough one for the world's biggest oil and gas companies. The steep decline in commodity prices is taking down revenue and profits across the industry. Even the best run companies have nowhere to hide. This is the peril of operating in a commodity business.
But at the same time, investors looking at the long-term picture should see a lot to like about the current state of Big Oil. Stock prices have come down significantly, which is scary to see, but it also sets up compelling opportunities going forward. Many Big Oil stocks are very cheap, and because their stocks are declining, their dividend yields are elevated to multi-year highs. If oil manages a recovery of any sort during the next several years, a solidly managed integrated major like Royal Dutch Shell (RDS.A) (RDS.B) could be a major winner.
Integrated structure provides protection
Brent crude oil, the international equivalent to West Texas Intermediate, has fallen all the way to $57 per barrel, down from more than $100 per barrel this time last year. This has weighed heavily on Shell, as it has for every other oil and gas major. But Shell held up better than many others last year.
Its earnings per share rose 14% in 2014. In the upstream business, profits benefited from increased high-margin liquids production volumes. Shell realized higher profits on the downstream side thanks to lower oil prices. Downstream profits surged 40%, to $6.2 billion.
Shell's downstream unit continued to perform well in the first quarter, even as the crash in commodity prices took its toll. Earnings per share declined 56% year over year, as upstream profits collapsed 88%, to just $675 million year over year.Natural gas caused Shell to take a hit, as its price is $2.81 per million British thermal units, down from nearly $4 this time last year. This is a big problem for Shell, because it is a major natural gas producer. Shell produced 9,400 million square feet of natural gas per day last quarter, which was a 1% increase from the average daily natural gas production last year.
But refining again provided a major lift, as downstream earnings soared 68% year over year. Granted, this wasn't enough to completely offset lower upstream profits, but Shell's results could have been far worse.
The reason for this is because downstream operations, such as refining, actually benefit from lower prices. When oil prices are volatile, it reduces refining feedstock costs and widens margins. This boosts downstream profits, and is a major reason why the integrated majors enjoy a tremendous operating advantage. This keeps profits relatively steady when compared to exploration and production companies that rely entirely on supportive commodity prices.
Shell is in a position to recover
Going forward, if oil and gas prices manage to recover from their lows, Shell will be in a great position to capitalize. One promising area is liquefied natural gas, or LNG, which is used for electricity generation and heating the home and is a major chemical feedstock. Shell is making huge investments in LNG. In fact, LNG was the principal reason for Shell acquiring BG Group plc for $70 billion earlier this year.
Shell stated it will have roughly twice the LNG production as close competitor ExxonMobil Corp. by 2018. With the takeover, Shell will be in prime position to export LNG to rapidly growing economies in Asia, where demand is expected to soar in the years ahead. If the deal closes, Shell will be the biggest LNG producer among international integrated majors.
Shell is a bargain now
Obviously, conditions are weak across the energy sector. According to a recent study by accounting firm Ernst & Young, Shell carries higher than average production costs at about $22 per barrel, while the broader industry average is $14 per barrel. In response, Shell will need to cut costs if energy prices stay low for an extended period. Fortunately, the company is responding, and has vowed to produce cost savings of $2.5 billion once the BG merger goes through.
But for investors looking ahead, Shell could be a huge winner if the environment improves. The stock trades for one times book value and five times enterprise value to EBIDTA. And Shell will return a lot of cash going forward. It offers a hefty 6% dividend yield, and the company plans to buy back at least $25 billion of stock from 2017-2020, assuming the successful completion of its acquisition.
Shell is getting hit hard by the commodity crash, but it's holding up fairly well thanks to its strong downstream business. Going forward, the company should reap significant benefits from its massive acquisition, placing it in prime position to capitalize on any recovery in oil and gas prices. In the meantime, the stock pays investors very well to wait for the turnaround.
