Royal Dutch Shell (NYSE: RDS-A), Europe's largest oil company by market capitalization, reported sharply lower third-quarter profits this week. Let's take a closer look at why the company's profits fell and what investors can expect going forward.
Why Shell's profits fell
Shell's third-quarter net income came in at $4.5 billion, down 32% from the year-earlier quarter, against analyst expectations of more than $5 billion. Though the rest of the oil majors that have reported earnings so far also fared poorly, Shell's was one of the biggest year-over-year declines.
ExxonMobil (XOM 1.08%), for instance, saw third-quarter earnings fall 18% to $7.87 billion, while Total (TOT +0.00%) and BP (NYSE: BP) reported year-over-year declines of nearly 20% and 26%, respectively.
Shell's profits fell due to a few important reasons, some of which were specific to the company and others that affected the entire industry. First was a 2% year-over-year decline in total oil and gas production, due largely to continuing challenges in Nigeria. During the quarter, a deteriorating security situation in the country and a blockade of Nigeria LNG reduced the company's profits by $300 million.
Perhaps the biggest contributor to Shell's poor quarterly performance was weakness in global refining margins -- an industry-wide phenomenon. Due to a contracting price differential between Brent crude and West Texas Intermediate crude, weak fuel demand in Europe, and maintenance activities at its refineries in Canada, Shell's downstream segment saw a massive 49% year-over-year decline in earnings, which came in at $892 million.
All the majors to issue earnings reports so far this season have cited the negative impact of global refining overcapacity and weak demand for fuel in the Western world, particularly in Europe, as the main reason behind sharply lower downstream earnings. For instance, Exxon saw its refining and marketing profit plunge 81% from a year earlier, while Total said downstream earnings fell 42% year over year.
Spending remains a concern
Compounding investors' concerns about Shell's disappointing quarterly performance is the fact that capital spending continues to rise. This year, the company is expected to spend a record $45 billion, about 50% more than it spent in 2012 and 12.5% more than it had previously indicated.
While 2013 spending was driven by a number of major acquisitions, including Shell's purchase of Repsol's LNG assets for $6.7 billion, net spending going forward is expected to be markedly lower. Shell is targeting capital expenditures of $130 billion from 2012 to 2015, meaning spending in 2014 and 2015 will have to total $55 billion if the company is to meet its target.
This should be achievable through continued asset sales, which have already commenced in full force this year. As part of a strategic review of operations in North America and Nigeria, Shell recently parted ways with poor-performing assets in the Eagle Ford and the Mississippi Lime and also put additional oil blocks in Nigeria up for sale.
Good news ahead
While Shell's third-quarter performance was disappointing by most measures, I think the company may have a brighter future. Next year, Shell plans to start up at least five new high-margin oil projects, including Mars-B and Cardamom in the Gulf of Mexico, which should boost 2015 cash flow by $4 billion.
Combined with future asset sales in the range of $10 billion-$15 billion, that could be enough to finance the company's massive capital spending program, as well as leave some surplus cash to be returned to shareholders through dividends and share repurchases. Furthermore, the company's leading position in global LNG should serve it extremely well over the longer term, given the highly cash-generative nature of these projects.
