Royal Dutch Shell: Virtue now or later?

Of course, we can debate that notion. Many top investors would say it is better to buy into great companies at decent prices than into those that might recover (or might not). Despite that, the Luke logic lies behind the decision of a New York activist investor, Third Point, to take a stake in the integrated oil major, Royal Dutch Shell (RDSB).

True, Third Point is also approaching Shell from the perspective of ethical investing, or ESG, as it’s now labelled. “Many ESG investors employ a strategy of buying companies that already have a clean bill of health,” it says. But it reckons that “it is often most impactful to invest in companies where the opportunity for positive change is the greatest”; adding that “there is perhaps no bigger ESG opportunity than in big oil and specifically at Royal Dutch Shell”.

Third Point is full of praise for Shell because it has already repented much of its sin by shedding fossil-fuel activity. The group went from owning 54 refineries in 2004 to just five at the end of 2020. Its combination of disposals and dividend cuts means that it carries little debt. Perhaps most impressive, compared with others in big oil, it generates more cash flow from “stable businesses that have a major role to play in the energy transition”. Such activities account for 40 per cent of Shell’s cash operating profits (ebitda) but, according to Third Point, are sexy enough to be worth all of its £163bn of enterprise value if they were a standalone business.

Yet its shares are penalised with a miserly rating. Table 1 shows they trade on the lowest multiple of both forecast earnings and operating cash flow for 2022 among the developed world’s five biggest oil companies. Third Point adds that the shares are on a “35 per cent discount on most metrics” to ExxonMobil (US:XOM) and Chevron (US:CVX).

The problem, reckons Third Point, is that Shell’s bosses are trying to make the group all things to all people and, by wanting to please everyone, Shell satisfies no one. “Shell has ended up with unhappy shareholders who have been starved of returns and an unhappy society that wants to see Shell do more to de-carbonise,” it concludes.

Its solution is straight out of the activist investor’s handbook – Shell’s bosses should break up the group. In theory this is a nice notion. It has some intellectual backing in company theory, which suggests companies should not exceed the limits of their competence. More pragmatically, there are analogies in the finance industry where badly damaged companies have basically split themselves into Bad Bank and Good Bank. The dud loans are dumped into Bad Bank, whose shares trade well below book value as a classic value play. Meanwhile, Good Bank will typically comprise fast-growing, fee-based operations, capital hungry but with predictable revenues and assured profits once income is sufficient for economies of scale to kick in.

It is easy to imagine a corresponding version for the integrated oil majors. Bad Oil will be the fossil-fuel upstream operation of oil wells and refineries, maybe even a little exploration. Within the next 40 years it will become a fossil itself; but not before it has delivered steady, though declining, returns to its shareholders, punctuated by the occasional crisis as society demands it pays still higher tributes to atone for past sins. Meanwhile, Good Oil will be the carbon-free side, comprising sustainable power generation up stream and distribution of zero-emissions electricity to happy motorists downstream.

Easy to imagine, but tougher to deliver. One factor is that Bad Oil is likely to be around for much longer than many like to imagine. Our World in Data website shows that 78 per cent of the world’s primary energy came from fossil fuels in 1992. By 2019, the supply of primary fuels was 60 per cent higher but the share provided by fossil fuels was slightly bigger (79 per cent). Besides, if – big if – large-scale carbon capture becomes a reality then demand for oil and especially for gas might hardly drop and Bad Oil would suddenly be not so bad after all.

So Big Oil will have to go carefully, not that Shell is going to split itself up any time soon. For starters, Third Point has next-to-no leverage. Its equity stake in Shell is about 0.4 per cent. Nor is its own investment performance certain to help its cause. The total return on shares in its London-listed closed-end feeder fund, Third Point Investors (TPOU), has lagged the S&P 500 index of US companies over the past 10 years and, only after a strong 12 months, is on a par with the MSCI World index. Meanwhile, the activist investor is having problems with an activist of its own who is fed up with the continual underperformance of shares in the closed-end fund against its net asset value. The activist’s campaign “serves as a means of drawing attention to itself”, says Third Point dismissively, apparently unaware of the irony.

This is entertaining and it helps prompt the question, which had been on my mind anyway, should I buy shares in Shell? One drawback is that there is no getting away from the fact that I would be buying into a declining industry, as Table 2 makes clear. Its data are annual growth rates for various measures in the period 2010-19 (2020 is excluded because it was so freakish). For sales, operating profit and capital spending (from which future growth should come) the data for all five western oil majors are resolutely down. For Shell, the possibly redeeming feature is that its rate of decline is mostly shallower than the others. Despite that – and perhaps because of the lack of capital spending – free cash generation has mostly grown, as have dividend payments, which helps explain the rise in net debt.

These are discouraging figures, partly redeemed – and especially in Shell’s case – by the fact that most companies’ shares have consistently traded around or below the book value of tangible assets. At Shell, the current price-to-book ratio of 0.7 is below the 2010-20 average, although at various times during this period its ratio has been 20 per cent above book value. This implies useful upside, especially for those investors who are encouraged by Shell’s progress in cutting greenhouse-gas emissions. In which case, Shell’s comparatively virtuous score in Table 3 is also good. It is based on marks out of 100 in five ESG-related categories supplied by data provider FactSet; Unilever (ULVR) is there solely to provide a reference with a company that screams its virtue.

Sure, bloody-mindedness might persuade me to go with ExxonMobil as the least reformed of the majors; especially as the dividend yield its shares offer is superior to Shell’s even after the unavoidable part of overseas withholding tax has been paid. But would it be better to pursue virtue now (Shell) or later (Exxon)? Oh Lord, having started with Luke the Evangelist, we seem to be ending with Augustine of Hippo. Enough.