Are Shell shareholders in for a windfall?

This time last year, you could have bought a barrel of West Texas Intermediate (WTI) for around $40 (£28.90). That same barrel would now cost you in the region of $72. With large drawdowns on US inventories taking place, the immediate prospects for crude prices are positive. 

We shouldn’t be surprised, then, that speculation over deal-making in the oil and gas space is intensifying. Reuters recently reported that Royal Dutch Shell (RDSB) was examining a possible sale of all or part of its Permian Basin assets in the US. Sources told the news agency that proceeds from a full sale could be more than $10bn.    

Shell has already taken measures to reduce its onshore presence in the US through an agreement to sell all but one of its oil refineries stateside. That looks a canny move in view of the steady ramp-up in US demand as travel restrictions ease across the country. More traffic on the interstates is pushing up crude prices, thereby narrowing the WTI/Brent Crude spread, which has the effect of reducing US refining margins. 

Shell’s Permian Basin assets account for around 6 per cent of group production, but exploration and production costs eat into margins simply because of the frequency of drilling that is required to maintain output. The general view is that the only way to consistently drive profits in the unconventional space is by upscaling operations. This explains why we are likely to witness further consolidation if prices keep rising. 

Existing targets ruled as insufficiently ambitious

But that’s only part of the story. The Anglo-Dutch group is being forced to accelerate its energy transition strategy because of a landmark court ruling in the Netherlands last month. In a legal action brought by Dutch environmental groups, The Hague District Court ruled that the group’s existing climate targets were insufficiently ambitious (or well-enough defined) and need to be brought in line with the targets set out in the Paris climate accords. It effectively means that by 2030, Shell must cut its CO2 emissions by 45 per cent from 2019 levels.  

Shell, understandably, has indicated that it will appeal the decision, but the ruling applies immediately and cannot be suspended before any appeal. In other words, the group won’t be able to use its deep pockets to drag it out through the courts. However, it is worth noting that the verdict is only legally binding in the Netherlands. 

Whether the ruling has forced Shell to mull over the future of its unconventional assets in the US is difficult to say, but if the civil court’s decision is upheld it could act as a catalyst for divestments across the sector if, as is possible, it leads to similar challenges across multiple jurisdictions.  

This could also act as a major disincentive for upstream investment, thereby further undermining the reserve-replacement ratio, which had already fallen to a 20-year low immediately prior to the pandemic.  

Wider issues aside, assuming Shell did garner something in the region of $10bn for its 260,000 acres, will any of the proceeds of the sale be likely to make it into the pockets of shareholders? 

Management at Shell deserves credit for the efficient restructuring of the group’s operation once the pandemic took hold. Rationalisation measures, including the culling of up to 10 per cent of the global workforce, have placed the group on a firmer financial footing, evidenced by an increased dividend and the planned resumption of share buybacks. 

Positive signs you would think, but it currently plans to increase its spending on renewables and low-carbon technologies to up to 25 per cent of its overall budget by 2025. Considering the court’s decision, it is conceivable that Shell could seek to accelerate investments in this area. And management may also be inclined to put said funds towards achieving its net debt target of $65bn, the point at which it plans to repurchase shares. The group exited 2020 with net debt amounting to $75.4bn, but a surge in cash flows reduced the liability to $71.3bn by the end of Q1 2021. 

Depending on the appeals process, the Dutch court ruling could eventually be viewed as a pyrrhic victory. And it is hard to understand why enforced divestitures would lead to an overall reduction in greenhouse gas emissions anyway. Shareholders would benefit if the monies are put towards debt reduction, rather than ploughing additional funds into renewables, but oil majors tend to throw off cash when crude prices are on the rise, further accelerating debt retrenchment ever prior to any potential Permian-linked proceeds. 

The Dutch ruling will certainly add to industry uncertainties, but given the oil price trajectory, investors would be justified in asking whether the group’s shares, down 38 per cent since the end of 2019, have been oversold given prospects for another dividend increase and the resumption of buybacks.