Royal Dutch Shell is a giant of a company. With a market cap of close to £200bn, this Anglo-Dutch oil major is comfortably the largest company on the UK stock market. The company touches most peoples lives through their direct investments or through indirect investments such as pension funds. To put its size and importance into perspective, it accounts for around 10% of the FTSE 100 index on its own. Its dividend to the market is even more important as it contributes 6%+ of the dividends paid by all UK listed companies.
A Breakdown Of The Shell Business
Shell is an integrated energy business. This means it has operations across the whole vertical energy chain. It has business units that participate in oil and gas exploration, production, marketing, refining, transportation and distribution. The whole shebang in short.
By having this structure in place, Shell has an almost unrivalled insight into the energy market. This structure also allows it to gain some benefits in almost any market condition., while higher oil prices are generally good news for Shell, they also have a negative impact on margins in its refining operations.
By far the biggest part of Shell is the integrated gas business which makes up 44.2% of 2018 earnings.
Shell undertook a huge £36bn merger with BG in 2016 to acquire this gas business. Natural gas is one of the cleaner energy sources and this acquisition was Shells response response to the changing patterns in energy consumption and growing political pressure over climate change. Shell has taken this giant leap into diversifying the company and only time will tell on whether this move turns out to be a success or not. But so far, natural gas is turning out to be a huge growth opportunity for the business.
The second biggest part of Shells business which compromises 26.4% of 2018 earnings is the upstream division. This business segment includes exploration and production of conventional oil and gas, deep water exploration and shale.
This part of the business is most exposed to commodity price volatility. It can be extremely lucrative in a high oil price environment but can be a burden when the oil price falls. That is why this division went from a loss of $3.7 billion in 2016 when the oil price took a hit to a profit of $6.8 billion in 2018 when oil prices recovered. This division is what I feel can make or break the company and that is why we will concentrate on oil prices below.
The downstream business which made 29.4% of 2018 earnings consists of refining oil and marketing refined products. It includes the Shell branded petrol station, the sale of fuel and lubricants. It is the steady eddie of the business. It made $6.6 billion in 2016, $8.3 billion in 2017 and $7.6 billion in 2018.
These disapparate business units means that Shell offers a lower risk profile than pure exploration and production oil companies. Its geographic span also means that if here are challenges in one region of the world then they can be more easily offset by improved performance elsewhere.
But in the end, Shell is a play on oil and gas prices. What these commodities do will determine the returns investors get by investing in shares of Royal Dutch Shell.
The Price Of Oil
In recent weeks, oil prices have collapsed to multi- decade lows thanks to a price war between Saudi Arabia and Russia, two of the largest producers in the world.
Further worsening matters for oil are the forced economic lockdowns caused by the corona virus which has wiped out over half of demand worldwide. This has resulted resulting in a huge oversupply in the market and has forced the oil priced lower.
This oversupply will only get worse the longer the lockdown stays in place and at this point the the only thing that can stabilise the oil price is an actual production cut by the oil producers’ cartel OPEC – not just empty words at a meeting.
Although everyone is focussing on these elements, these are by no means the only factors affecting oil – in the long run anyway
The Death Of Oil?
There is the global warming aspect as well.
The oil and gas industry contributes to 42% of global emissions according to global consulting firm McKinsey.
There is a growing chorus of climate activists that are applying pressure on governments and companies to dramatically reduce the use of oil and take us in to an oil free world.
This has a two pronged effect.
The first being a growing portion of the investment industry facing pressure to turn away from fossil fuel-based investments amid increasing focus on environmental, social and governance (ESG) issues. When this happens, they sell fossil fuel related stocks, causing demand for them to crater and the share prices to fall. Capital shifting out of oil and gas shares creates a vicious circle for the sector whereby their weighting in global indices decreases and they are therefore less widely held by tracker fund.
The second is the huge amounts of research being done into technologies to reduce the worlds thirst for oil, particularly in the transport sector. Oil for transport accounts for 60% of the entire 101m barrels per day global oil market. The growth of the electrical vehicle industry is seen as an existential threat to the oil and gas sector. But this transition is unlikely to be smooth. Just take California, one of the words most environmentally conscious places, the vast majority of car sales remain gasoline-powered. Pure electric cars account for just 5.5% of California’s vehicle sales (or 13% when including all types of electrification), compared to 81% for petrol cars.
So this transition to electric vehicles won’t happen overnight. It will probably take far longer than what people think.
Oil consumption is still growing around the world. Increasing global prosperity will cause the demand for oil to only increase over time.
To understand how increased global prosperity and the emerging middle class will affect oil, we need to look at nations that are already developed. Nations that have a high standard of living and industrialised economies.
Today, the U.S. is the largest consumer of oil on the planet. The U.S. uses about 7.2 billion barrels per year, or nearly 20 million barrels per day.
Another ‘first world’ country, Japan, also uses copious amounts of oil, around 1.8 billion barrels per year or nearly 5 million barrels of oil per day.
Together, these two countries alone consume 25% of all oil produced globally. Yet when you zoom out you realise that the total population of both countries is only around 450 million people – around 6% of the world’s population.
Meanwhile, China has a population of nearly 1.4 billion. It uses 4 billion barrels of oil per year – about 11 million barrels per day. In other words, the U.S. – with a population about one-fifth the size of China – consumes almost two times more oil. And this is where it gets interesting. China is in the middle of another industrial revolution. Poverty is decreasing, and the middle class is growing. The standard of living is on the rise. The Chinese are driving cars and scooters, watching TV, using a lot of electricity, and making a lot of stuff. By next year, China is set to overtake the U.S. as the world’s largest importer of crude oil.
The story of china is truly amazing.China’s economy has grown 900% since 1999. Over that period, it has grown to be the world’s second-largest economy at more than $10 trillion. Instead of bicycles crowding the streets, the Chinese are driving cars and scooters. Vehicle sales have exploded, and demand for oil has nearly tripled in the last 20 years alone. And it is still growing.
And if you think China is promising, you ain’t seen nothing yet. For as big of a catalyst as China will be for oil prices, India has even more potential to move the needle. There are around 1.3 billion people in India – around three times the combined population of the U.S. and Japan. India uses 1.5 billion barrels of oil per year, or about 4.1 million barrels per day.
That’s just a fraction of the oil used in China. But India is expected to add another 241 million “people of working age” by 2030. And you can bet that most of them will be driving cars, watching TV, and making stuff. Soon, India will pass China to become the world’s highest-populated country. Because of this India is expected to be the fastest-growing consumer of crude oil in the world through 2040, adding 6 million barrels a day of demand.
Countries all across the world, as they become more prosperous, will use more oil. The world is far away from eradicating its thirst for oil.
Never Sell Shell
There is a famous saying “ Never Sell Shell”. Even with the latest fall in the oil price, Shell has turned out to be a great investment for those who have held the stock over the years.
Let’s look at my own holdings in Shell which I have owned since 2016. I bought 215 shares outright and came to be the owner of 42 more shares through my BG holdings which got taken over by Shell. In total, my 256 holdings came at a price of £14.75 each.
Looking at Shell’s price today of £14.72, it looks like I have lost money on my shares.
But that is not the case. We need to factor in the the dividends I have received over my holding period. In total, Shell has sent my way £1,560 in cold hard cash. Taking this into consideration, I am actually up 40% on my purchase. Or to put it in other words, my investment in Shell has provided me a return of 10% a year. Not bad
So even though the share price is at a similar level to where it was 4 years ago, I am up 40% because of dividends. We cannot ignore dividends when checking return. For giant mature companies like Shell, the majority returns will come from dividends.
On the other hand, if someone had bought Shell when it was trading in the mid £20’s, they have lost a significant amount of money.
And this brings me to another point – Only Buy Cyclical Stocks At Cyclical Bottoms.
Before I go any further, let me explain what cyclicals are. Cyclicals are industries whose profits and stock prices rise and fall with the economic cycle. Automobile manufacturers, oil companies, house builders and steel or aluminium producers are classic examples.
With Cyclicals, the price you pay is everything. If you pay too high a price, you risk losing a huge part of your capital. If you pay a low price, you stand in good steed to make a truck load of money.
The reason for this is because cyclicals move in constant boom and bust cycles. The worst time to buy is at the top. Many people know this in theory but it is very hard to apply in practice. This is because at the top of the market, unlike other sectors, cyclical stocks often appear cheap.
They have low P/E ratios as they are making huge swarms of money at the top. But unlike a consumer staple company for instance, cyclical stocks don’t make record profits year after year. Their profits are lumpy and hugely dependent on the economy. So if you buy after record profits when the stock looks cheap due to the E (earnings) in the P/E ratio being inflated, you will be in for a nasty shock.
This is why Peter Lynch said the worst time to buy a cyclical stock was when the past financial performance was at its best. In another words, when the trailing PE ratio of a cyclical stock is low, it usually means the stock is nearing the end of the cycle.
On the other hand, when the P/E ratio of a cycle stock appears high, it is often the time to buy.
This is because the E (earnings) in the P/E ratio is depressed due to the industry being at the low point of its economic cycle. You want to be buying when industry profits are low so you can ride the economic wave upwards.
So while at present shares in Shell might appear expensive due to the fall in earnings, now could be the best time to actually buy shares in the company.
My Purchase Of Shell
As mentioned in my March stock purchase post, I bought a chunk of Shell shares a couple of weeks ago to add to my existing holdings. I bought 94 shares in Shell B class shares at a price of £11 each.
I bought B class shares (RDSB) instead of A class shares (RDSA), due to B class shares having no dividend withholding taxes to pay. As a UK based investor, RDSB is the better buy as you get the full amount of dividend instead of having 15% taken off in the form of withholding taxes.
At the price paid of £11 a share, I in no ways bought at the recent market bottom. After my purchase, shares in Shell fell further to reach a low of £8.89.
But this didn’t irk me. I know it is impossible to time markets. All that is in my control is the price I pay. And for me, I feel the price I paid will give me a good double digit rate of return going forward.
Obviously, a huge part of my return will depend on oil prices from here on out. It’c currently rough out there. But I feel things will turn. I think the super majors such as Shell stand to come out even better by virtue of companies in the sector going bankrupt thus reducing competition.. It’s tough to say how long this will go on, but there’s that old saying in the industry ‘the cure for low oil prices is low oil prices’.