Royal Dutch Shell plc (NYSE:RDS-B) CEO Ben van Beurden recently warned that the company would miss fourth quarter expectations by a wide margin. Mr Beurden, who became the head of the Anglo-Dutch company two weeks ago, said adjusted earnings for the fourth quarter would be around $2.9 billion versus analyst expectations of $4.9 billion.  

The stock fell by 4% before recovering and finishing down 0.9%.

The expected miss is a result of higher costs in exploration and refining and lower production in oil. Oil exploration is becoming more and more expensive now that the easy oil is gone. Refining in Europe is increasingly a losing proposition with American refiners using cheaper WTI and $4/MMBTU natural gas for inputs versus the more expensive Brent and $11/MMBTU natural gas for European refiners. 

Royal Dutch Shell also saw lower oil production due to instability in Nigeria. 

The company is not alone in feeling the pain. Fellow super-major Chevron (NYSE:CVX) recently warned that its fourth-quarter upstream earnings would not meet expectations due to lower oil production. Chevron's total earnings, however, will be comparable to its third-quarter total. 

Short-term headwinds
Integrated oil majors generally make most of their profits upstream. In 2012, Chevron realized profits of $23.7 billion upstream versus $4.3 billion downstream. For the same year, Royal Dutch Shell earned $22.1 billion upstream versus $5.3 billion downstream. 

Of the three super-majors, ExxonMobil (NYSE:XOM) is the most diversified. For 2012, it earned $29.9 billion upstream out of its total $44.9 net income. 

Upstream profits depend on high Brent prices. Unfortunately several factors currently hinder Brent's rise:

  • Expectations of rising oil production and eventual exports from Iran
  • Lower risk premium for crude oil due to U.S. detente with Iran 
  • Rising oil exports from Iraq (although this region may be unstable)
  • China's economy is still weak -- China's implied oil demand rose by only 1.6% in 2013  
  • Saudi Arabia, which has historically cut production to prop up oil prices in times of oversupply, recently said it will no longer unilaterally cut oil production unless other OPEC countries do as well -- Saudi Arabia needs as much oil revenue as it can get to finance its generous social programs 
  • Continued increase in U.S. oil production due to the shale revolution: According to the Energy Information Agency, U.S. crude oil production rose by 1 million barrels/d in 2013 to reach the highest level in 24 years -- the U.S. increase in oil production was higher than the combined increase of oil production in the rest of the world 
  • Higher vehicle efficiency mandates: The White House has a mandate of reaching average fuel economy of 54.5 miles per gallon for vehicles by 2025 -- the mandate will save 12 billion barrels of oil. 

While their upstream revenue growth is largely constrained due to range-bound Brent, Royal Dutch Shell and other super-majors are seeing higher production costs. They are seeing higher costs because they are increasingly competing against well-funded national oil companies and Chinese oil companies whose number one objective may not be to optimize profits. These state companies sometimes bid up projects to unattractive levels.

The bottom line
To counter short-term headwinds and improve capital allocation efficiency, Royal Dutch Shell announced that it will divest $15 billion in non-core assets over the next two years. The company canceled plans to build a $20 billion gas-to-liquids plant in Louisiana last month. It recently sold some projects in the North Sea. It may also divest some of its assets in Nigeria. 

In the long term, Royal Dutch Shell should still do well. Management expects annual production to increase to 4 million bboe/d by 2017 from the current 3.3 million bboe/d. If management can execute, even if the price of Brent stays the same, Royal Dutch Shell will see higher profits based on production volume increases alone.

Another positive is that Royal Dutch Shell is the world leader in LNG, with 22 million tons of LNG production in 2013. LNG demand is increasing rapidly. Many analysts expect LNG demand to double to 500 million tons a year by 2025.  

By warning before earnings on January 30, Beurden is getting the bad items out of the way so he can work with a clean slate. Large oil companies optimize their energy portfolios for the long term, so they may at times disappoint in the short term. If Royal Dutch Shell can improve its capital allocation efficiency, it will continue to be a good investment for the long term.