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Article Thesis
Shell (NYSE:SHEL) is one of the biggest oil and gas companies in the world. The company’s results for the fourth quarter were strong, and Shell continues to make progress when it comes to strengthening its balance sheet. The profit outlook for the current year remains very healthy, and since the dividend payout ratio is pretty low, investors can expect more dividend growth in 2023, I believe.
The Outlook For Oil And Gas Markets
In 2022, energy markets were very volatile. On the back of the ongoing war in Ukraine, oil soared to the highest level in more than a decade during the summer of 2022. Due to worries about an economic slowdown in the US, Europe, etc., oil prices pulled back over the last half year, however. China’s COVID policies with massive lockdowns in many cities through the end of 2022 also played a role in oil prices getting weaker again, as these lockdown measures in China hurt global oil demand.
But with oil around $80 per barrel, many energy companies are still very profitable — despite the fact that oil traded significantly higher at some points in 2022. Oil prices at the current level are thus by far not a disaster for energy companies — quite the contrary: If oil remained at around $80 per barrel forever, I believe many energy players would be attractive investments at current prices as they are trading at undemanding valuations if earnings and cash flows remain high. If the world does experience a major recession, oil prices could head lower, of course. But it’s also possible that oil prices will climb over the coming months — I believe that this is more likely than a declining oil price. Several factors should be considered:
– China’s economic reopening will drive oil demand in the country. People in China are driving more, for work purposes and for personal purposes. They also fly more, and when the economy is picking up, demand for oil will also grow due to higher plastic production, etc.
– Sanctions against Russia’s oil industry have not resulted in a big export drop so far, but will likely result in output declines in 2023 and beyond. With Western tech not being available for new projects and for maintenance of existing assets, it seems likely that field declines will result in less overall production capacity in the future.
– A recession may not happen, and even if it happens, it will most likely not last for many years. Even if a recession were to occur, which is not guaranteed, oil demand would likely pick up again a couple of quarters later.
– A growing middle class in countries such as China, India, and others will increase global oil demand in the foreseeable future, as more and more consumers in these countries are buying vehicles, traveling on airplanes, and so on.
– Spending on new major projects has slowed down considerably in recent years, due to a combination of regulatory pressures, oil companies being more focused on free cash flow generation, and so on. This will likely mean that supply growth will be subdued. In combination with growing global demand, weak supply growth could result in a “higher for longer” environment of steady or even growing oil prices.
Likewise, the market outlook for natural gas, at least in import markets such as Europe and parts of Asia, is strong as well. Natural gas is needed for electricity generation to balance out the volatility of wind and solar, and natural gas is also still used a lot for heating, cooking, etc., which will most likely not change meaningfully in the near term. With Europe seeking to diversify its supplies away from Russia, natural gas prices on the continent should remain high.
All in all, this makes for an attractive macro environment for energy companies such as Shell. Its global oil business benefits if oil prices remain high or climb further, while its integrated gas business benefits from elevated natural gas prices in Europe thanks to Shell’s LNG capacity.
Strong Results In 2022, And Likely Also In 2023
Shell reported its most recent earnings results, for Q4 and FY 2022, on Thursday. During the quarter, the company generated an adjusted net profit of $9.8 billion — the second-highest ever quarterly profit in the company’s history. That was true despite the oil price pullback seen over the last half year, which shows that oil prices in the upper double-digits range are far from a disaster for Shell — that’s still a very compelling environment for the company, as Shell can operate very profitably with oil prices in this range.
Adjusted net profit came in at $9.8 billion for the quarter, or almost $40 billion on a run rate basis. For all of 2022, Shell earned $39.9 billion of net profits — relatively comparable to the Q4 run rate. This suggests that profits in 2023 could be at a more or less comparable level if oil prices remain where they are today.
Shell’s adjusted earnings per ADR (one ADR equals 2 shares of Shell) was $2.78 — which makes for a run rate of a little more than $11 per ADR. Relative to the current share price of $58, that seems very attractive, as it makes for an earnings multiple of just above 5. This equates to an earnings yield of close to 20% — pretty cheap for a company that is well-positioned to benefit from the ongoing global energy shortage for a prolonged period of time.
Profit generation is important, but one can argue that cash flows are even more important — after all, cash flows decide a company’s potential when it comes to growth spending, M&A, debt reduction, and shareholder returns. Shell’s strategy when it comes to capital allocation has been a mix of several of these options in recent years: The company spends on growth projects, both in the hydrocarbon space as well as in the renewable/green energy space, while Shell has also been paying down debt. Last but not least, Shell has been returning billions of dollars to its owners via a combination of share repurchases and dividends. While some investors do not like buybacks and would prefer higher dividends instead, I believe that Shell’s buybacks are a good idea — when a company can repurchase shares at an earnings yield of 20%, that’s a high-return option without any of the risks of growth spending, such as cost overruns, delays, and so on. Shell’s hefty buyback spending in recent quarters is thus beneficial for shareholder value in the long run, I believe.
During 2022, Shell generated free cash flows of $46 billion. Capital expenditures of $23 billion are already accounted for here, and the operating cash flow number included a negative working capital impact of $5 billion — at unchanged working capital levels, free cash flow would thus have come in at more than $50 billion, which is extremely impressive, especially when we consider that Shell is valued at just above $200 billion. In other words, the trailing free cash flow yield is north of 20%, while the adjusted free cash flow yield (backing out the working capital impact) is almost 25%. This shows Shell’s massive potential when it comes to returning cash to its owners. In 2022, Shell pursued some minor M&A and paid down $8 billion in net debt. This has lowered Shell’s gearing ratio, its favorite measure for its indebtedness, to 18.9% — well below the levels seen over the last couple of years, and down 420 base points over the last year alone. Shell might pursue further net debt reduction in the coming years, although it’s not really needed — the $45 billion net debt position is smaller than Shell’s free cash flow over the last year.
I thus believe that shareholder returns will remain in focus going forward. Shell has already announced a 15% dividend increase to $0.575 per ADR per quarter, which has made Shell’s yield climb to 3.9%. While that is less than what investors can get from most energy midstream players, it’s considerably more compared to what is available from Chevron (CVX) and Exxon Mobil (XOM) — they offer dividend yields of 3.5% and 3.2%, respectively. At the same time, Shell’s payout ratio looks very favorable versus its two American peers: With the dividend at the current level, the annual payout totals $8 billion, or around 17% of Shell’s 2022 free cash flow. Exxon Mobil and Chevron have payout ratios of 26% and 30%, respectively, meaning they need to pay out more than one and a half times as much of their FCF relative to Shell, while still offering a lower dividend yield. This should result in more growth potential for Shell’s dividend, and it also could make Shell’s dividend safer — although investors don’t need to worry about XOM or CVX’s dividends, either.
Shell has announced a new $4 billion buyback program for the current quarter, enough for around 2% of its shares. This will reduce the share count further, in line with what has happened in the recent past — Shell has reduced its share count by 8.5% in 2022, net of share issuance, which is pretty attractive.
Final Thoughts
Oil prices have pulled back over the last half year or so, but that hasn’t hurt Shell’s profits meaningfully. The company is still very profitable with oil at $80, and due to several macro factors, oil prices could climb in the foreseeable future. But even if that does not happen, current profitability levels are very attractive. Shell can pursue further balance sheet strengthening while offering more dividend increases on top of the recent ones. Its yield is solid as well, at almost 4%, and the ongoing buybacks could provide support for shares. If oil prices were to fall a lot, Shell’s stock would be at risk, but I do not believe that a major oil price decline is very likely — such a scenario would require a very deep recession, I believe.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
