Just about everyone recognizes that famous scallop shell logo of Anglo-Dutch company Royal Dutch Shell. For more than a century, Shell has been a household name when it comes to oil and gas. The reason that we all know the company -- those retail stations everywhere -- are only a small part of this integrated oil and gas behemoth. From an investor's standpoint, it's those things we don't see everyday that have the potential to keep share price growing.
I'm not a soothsayer, so I can't predict where Royal Dutch Shell's share price will be in the next couple of weeks, months, or even a year from now for that matter. Companies the size of Shell plan and develop new projects for several years before they bear fruit, and lots of things can happen in between. Keeping this in mind, let's take a look at three reasons why you should be optimistic on the future of Royal Dutch Shell.
1) Long-term outlook for supply and demand of oil and gas should remain strong
Of all the major players in the integrated oil and gas industry, Shell generates the largest percentage of its earnings from its downstream refining, chemical manufacturing, and marketing segments. That being said, it's still a relatively small portion of the entire business. In 2013 refining, chemical manufacturing, and retail sales accounted for only 25% of Shell's earnings, and that was the highest percentage these downstream segments have contributed in the past five years.
What this means for investors is that you need to focus a much larger percentage of your time analyzing the upstream side of the business, where the actual production of oil and gas takes place. This isn't just true for Royal Dutch Shell, it applies to every integrated oil and gas company out there.
To best understand oil and gas production, you also need to understand the supply and demand outlook for these energy commodities. Shell publishes quite possibly the most thorough outlook material of any oil and gas company, and according to their multiple growth projections, oil and gas demand will continue to grow considerably over the next several decades until it starts to flatten out by 2040.
Considering these two outlooks, it is pretty safe to assume that an investment in an oil and gas company is a pretty safe bet for the next few decades. Providing that Shell can execute its global development plan and continue to discover and extract new resources, then there should plenty of room for it to grow for many years to come.
2) Disciplined capital allocation should drive higher returns
One of the biggest critiques of Royal Dutch Shell over the past several years has been its relatively weak performance in relation to its peers, more specifically its return on capital employed. Since 2009, Shell's return on capital employed was less than half that of its largest peer, ExxonMobil, and it had the worst ROCE of its peer group last year.
In order to address this shortcoming, Shell's management has initiated a massive portfolio review and is divesting itself of its weakest performing assets. So far this year, Shell has unloaded over $8 billion in various business segments and plans on another $10 billion-$15 billion in divestitures by the end of 2015.
On top of that, the company is scaling back its capital expenditures. Capital spending excluding acquisitions and divestitures in 2014 is expected to be 20% less than the year previous, and management expects capital spending to remain in the $37 billion range for the next few years as it looks to be more discerning when it comes to taking on new projects.
The overarching goal of these moves is to increase free cash flow that can be used to fund the company's dividend as well as return value to investors through buybacks. Based on the results so far this year, it actually looks to be working. In the first half of 2014 alone, Shell has generated almost as much cash as it did in all of 2012.
Generating strong cash flows for shareholder-friendly initiatives can go a long way for increasing share value over the long term, and if Shell can maintain this pace it should be able to do just that over the next several years.
3) A strong emphasis on the global LNG market
For decades, natural gas was an energy source that needed to be developed on a regional basis because the economics of moving it overseas wasn't very strong. That simply isn't the case anymore. Thanks to huge regional price discrepancies for natural gas and more advanced liquefaction technology, gas is becoming more and more of a globally traded commodity. For years, Shell has been a major player in the natural gas market, and it appears that it hopes to further solidify that position over the next several years.
Currently, there are more than 700,000 barrels per day of oil equivalent on Shell's books from LNG production and trade, which is just under one quarter of Shell's total production output. When you add all of the projects that are currently being designed, Shell anticipates that number to climb to 1.24 million barrels per day of oil equivalent. On top of its production and liquefaction facilities, Shell also has a large fleet of its own transport vessels as well as multiple regasification terminals globally that allow it to act as an entity that delivers gas from source to end use.
A major added benefit of this transport and handling network is that they have the potential to last several years without massive added capital expenditures, and it puts itself in a position to control the transport and distribution of gas globally. As natural gas becomes a larger and larger part of our energy mix, Shell should be well positioned to benefit.
What a Fool believes
The basic premise for investing in other integrated oil and gas companies holds just as true when it comes to Royal Dutch Shell. It you plan on buying shares, then you should be considering it as an investment you plan to hold for years and potentially decades. With a current dividend yield of 5.3% on top of Shell's future plans to increase cash generation, holding shares over several years and reinvesting those dividends will go a long way in generating value. Based on the outlook for oil and gas and the position Shell is carving out in the global LNG trade should go a long way in increasing share prices from today's levels.