2023-12-16 07:56:41 ET
Summary
- My bearish inflection for SHEL relates to a less favorable outlook for energy prices compared to six/ nine months ago.
- OPEC+ cuts, despite significant, fail to support oil prices, with record oil production from the US being a major challenge.
- Shell's financial performance is strong, but earnings are trending downwards compared to FY 2022.
- In 2024 and 2025, Shell's estimated free cash flow may not fully cover 2023-like dividends and buybacks, potentially leading to a negative surprise for shareholder distributions.
I am downgrading Royal Dutch Shell (SHEL) stock to "Hold", and I cut my base case target price to $81.4 per share, down from $101.47 per share estimated previously . The main reason for my bearish inflection relates to a less favorable outlook for energy prices compared to six/ nine months ago. Specifically, I am concerned about a normalization of global energy prices markets from 2024 onward, which will pressure Shell earnings power and ability to distribute cash to shareholders.
For reference, after the enormous share price rally from late 2020 through 2022, oil majors such as Royal Dutch Shell have started to under-perform again: Since the start of the year, SHEL stock has appreciated by less than 15%, compared to a gain of approximately 20% for the S&P 500 ( SP500)
OPEC+ Cuts Fail To Support Oil Prices
On November 30th, OPEC+ producers have agreed to extend voluntary oil output cuts into at least the first quarter of 2024. In that context, the OPEC+ meeting outcome broadly aligned with market projections that Saudi Arabia would prolong the 1mb/d output through March next year, with additional voluntary cuts by Russia, Kuwait, UAE, and Iraq totaling 1.15mb/d cumulatively. Although these cuts are quite significant, it is notable to point out that the meeting's outcome failed to support oil prices. In fact, oil prices started to trade lower almost immediately following the announcement and have extended losses to almost 10% since.
One major challenge for the OPEC+ group to support prices on lower supply is anchored on the record oil production coming from the U.S. According to data collected by the International Energy Agency ((IEA)), the US contributed about 80% to this year's global oil supply expansion, adding 850,000 b/d in its production compared to 2022. And while the OPEC+ is cutting, there are quite a few signs that the U.S. is growing bolder in its bet on fossil fuels, following a period of austerity. This year, Exxon has entered into a $60 billion acquisition deal with Pioneer , while Chevron is allocating $53 billion buying Hess. On a related note, Chevron also announced its anticipation to allocate $18.5 to $19.5 billion for new oil and gas projects in the upcoming year, marking an 11% increase from the investments made in 2023, while Exxon aims to allocate between $22 billion and $27 billion annually until 2027.
All that said, it is notable to point out that markets are now pricing WTI future prices in slight backwardation (low duration futures prices higher than long duration futures prices). Needless to say, backwardation occurs primarily as a result of higher demand for an asset currently compared to the demand for contracts maturing in the later month. The backwardation is even more significant when discounting the futures prices with an implied 5% yield on treasuries.
First Signs Of Earnings Pressure Are Flashing
Overall, Shell's financial performance continues to be very strong. During the period from June through end of September, the European oil major generated about $76.4 billion in sales, $16.3 billion in adjusted EBITDA and $5.1 billion in adjusted earnings. However, switching perspective to the trailing twelve months, which includes Q4 2022, it is quite evident that Shell's fundamentals are trending downwards compared to the FY 2022. In fact, Shell's revenues, operating income and earnings from continuing operations have contracted by 11%, 13%, and 31%, respectively.
Expecting that the Brent price will trend around $70-75/b though 2024 and 2025, I estimate Shell's FCF at around $20-25 billion per year, or a yield of 10.5% compared to the company's current market capitalization. While the FCF on an independent observation continues to be quite attractive, I point out that compared to the company's cash distributions, the number is barely able to cover the current TTM run-rate of dividends($8 billion) and buybacks ($15.8 billion). In other words, if oil prices remain pressured, which I expect, investors may likely see a negative surprise on shareholder distribution -- especially if CAPEX ramps up to levels seen in the early decade starting 2010, where capital spending per year was $25-30 billion vs. $20-25 billion currently.
Valuation Update: Lower Target Price To $81
Looking ahead, I anticipate that oil prices will remain elevated in 2023, with the Brent benchmark projected to fluctuate within the range of $60 to $80 (likely skewed towards the higher end of the range). If this forecast holds true, it could translate to substantial profits for Shell, potentially reaching $25 to $35 billion (likely skewed towards the higher end of the range).
That said, as compared to my post-Q4 guidance for 2023, I now raise my EPS expectation for Shell through 2025 by about 10%. However, I continue to anchor on a 0% terminal growth rate (one percentage point higher than estimated nominal global GDP growth), as well as on a 9% cost of equity.
Given the EPS updates as highlighted below, I now calculate a fair implied share price for SHEL of about $81.4.
Author's EPS Estimates and Calculation
Below is also the updated sensitivity table.
Author's EPS Estimates and Calculation
Conclusion
Despite a strong financial performance in recent months, with Q3 sales of $76.4 billion and adjusted earnings of $5.1 billion, Shell's fundamentals show early signs of earnings pressure with a contraction in revenues and operating income for TTM vs. FY 2022. That said, Shell faces challenges coming from a normalization of global energy prices. Meanwhile, OPEC+ production cuts have struggled to support oil prices, given the substantial U.S. oil supply expansion. Anticipating oil prices around $70-75/b in 2024 and 2025, Shell's estimated free cash flow may not fully cover 2023-like dividends and buybacks, potentially leading to a negative surprise for shareholder distributions.
Responding to a less favorable energy price outlook in 2024 vs. 2023, I am downgrading Royal Dutch Shell stock to "Hold"; and I am revising my base case target price downward to $81.4 per share (SHEL reference).
For further details see:
Shell: Early Bearish Inflection Signals Are Flashing