Royal Dutch Shell (NYSE: RDS-A) just issued a big profit warning for the fourth quarter of 2013, bringing its expected full-year 2013 earnings to $16.8 billion. This is a significant fall from its 2012 full-year earnings of $27.2 billion. Thanks to upstream cost overruns and downstream overcapacity, 2013 probably will not be the last year Shell faces low earnings.
Downstream challenges
Shell's refineries put a hole in its Q4 2013 earnings. Its Asia-Pacific and European refineries are facing margin pressures and for good reason. They don't have access to cheap U.S. crude. They are forced to buy expensive Brent crude and pay a premium relative to U.S. refiners. Also, U.S. refiners have access to cheap natural gas and natural gas liquids.
As of Dec. 31, 2012, Shell had equity interests of at least 13% in eight Asian refineries. As if feedstock issues weren't enough, the Asian refinery market is facing overcapacity and low margins for years to come. Thanks to expansions in India, China, and other nations, analysts project that Asia could have a refining surplus of up to 3 million barrels per day in 2018.
HollyFrontier (HFC +0.00%) is the opposite of Shell. HollyFrontier operates five small refineries with a total capacity of 443,000 barrels per day of capacity. Thanks to its location in the American Midwest it has great access to cheap crudes, with a number of promising investments on the table. For $300 million HollyFrontier is expanding its Woods Cross facility to produce a relatively secure $125 million in additional annual earnings before interest, taxes, depreciation, and amortization.
HollyFrontier does have its challenges. The closing Brent-West Texas Intermediate spread will put downward pressure on its net income. HollyFrontier's 2012 net income per barrel was more than $10, but it could head toward the $2.69 average it posted from 2001 to 2010 when WTI traded at a premium to Brent.
Shell's upstream challenges
The huge Gorgon LNG project keeps seeing cost increases. Recently the big partner, Chevron (CVX 0.95%), upped the project's cost by $2 billion to a total of $54 billion. This cost increase comes after Chevron previously added $15 billion to Gorgon's price tag. Cost overruns are hurting Big Oil across the board, as Shell and ExxonMobil (XOM 1.63%) each own 25% of Gorgon.
Not only is Gorgon facing big challenges, the Shell-ExxonMobil-Total-KazMunaiGas-Eni Kashagan project was recently shut down due to pipeline leaks. The field's current $50 billion cost is more than five times its original price, and recent delays have pushed back its commercial start date even further. High levels of hydrogen sulfide make production especially difficult and point to further setbacks in the years to come.
In addition to the aforementioned problem projects, Shell's expensive Arctic drilling has come up short.
Delays and cost overruns in these big projects mean more of Shell's cash must be diverted toward capital expenditures. At the same time there is less money flowing in from production. From 2012 to 2013 Shell's net capital investment is expected to increase from $29.8 billion to $44.3 billion. Lower upstream volumes are another negative factor for Shell, helping to push expected Q4 2013 upstream earnings down to $2.5 billion from $4.4 billion in Q4 2012.
Once more of Shell's big upstream projects come online, its volumes and earnings should head upward; but it may be a number of years or more until the major kinks are worked out.
Shell is not alone
Cost overruns and upstream production challenges are not unique to Shell. In the last four quarters, ExxonMobil saw its revenue fall from $126 billion to $109 billion and its EBITDA fall from $33 billion to $15 billion. Its presence in both the Gorgon and Kashagan projects has put stress on ExxonMobil's capex budget.
Just as Shell is having problems trying to maintain its upstream volumes, ExxonMobil is facing similar challenges. ExxonMobil was able to boost its Q3 2013 upstream volumes relative to Q3 2012 but only by 1.5% on an oil-equivalent basis. In Q3 2013 it produced a massive 4 million barrels of oil equivalent per day, and there is a good chance this could fall slightly in the coming years. There are only so many mega-projects available in the world.
Chevron is a different story
Chevron will have an easier time maintaining its upstream volumes than ExxonMobil. In Q3 2013 it produced 2.6 million barrels of oil equivalent per day, significantly less than ExxonMobil's 4 mmboepd. Chevron is active in the Vaca Muerta region in Argentina, off the coast of the Congo, and it is already producing in the Brazilian Papa-Terra field.
In the last four quarters Chevron's EBITDA did fall from $14 billion to $11 billion, but compared to ExxonMobil it fared much better. Overall Chevron's smaller size will help it to be more nimble and stay out of projects like Kashagan.
Final thoughts
Shell is a massive company stuck with many refineries and expensive greenfield projects. It has a challenging future ahead as it struggles to bring large upstream projects online and on budget. Investing in smaller companies like HollyFrontier or Chevron helps you make sure that your investment dollars are shoved into fewer $50 billion dollar quagmires.
