Shell Earnings Preview: Lower Upstream Earnings, Thicker Downstream Margins Expected

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RDSA: Royal Dutch Shell logo
RDSA
Royal Dutch Shell

Royal Dutch Shell Plc. (NYSE:RDSA) is scheduled to announce its 2014 fourth quarter earnings on January 29. We expect lower crude oil prices to weigh significantly on the company’s upstream earnings growth. Benchmark crude oil prices have declined sharply over the past few months on rising supplies and falling demand growth estimates. The average Brent crude oil spot price declined by more than 30% year-on-year during the fourth quarter. This is expected to result in thinner operating margins on Shell’s spot crude oil sales. However, lower exploration expense and thicker refining margins are expected to partially offset the impact of lower oil prices. During the earnings conference call, we will be looking for an update on Shell’s ongoing divestment program and its operating strategy under the changed crude oil price environment.

Shell is an integrated oil and gas company that is registered in England and Wales and headquartered in The Hague, the Netherlands. It has a strong global presence. The company is involved in the principal aspects of the oil and gas industry (exploration and production of hydrocarbons, refining and marketing of petroleum products, and chemicals manufacturing) in more than 70 countries worldwide. This geographical diversity of Shell partially insulates it from operational and financial risks arising from regional regulatory and geopolitical uncertainties. We currently have a $71/share price estimate for Shell, which is almost 12.2x our 2015 full-year adjusted diluted EPS estimate for the company.

See Our Complete Analysis for Royal Dutch Shell Plc.

Lower Exploration Expense

Lower oil prices are expected to have a significant impact on Shell’s upstream earnings. According to the company’s 2014 third quarter earnings call transcript, 65% of its upstream revenues are directly linked to crude oil prices and a $10 per barrel decline in Brent crude oil prices translates into a $3.2 billion earnings impact on an annual basis. This means that depending upon the overall lag (between fluctuations in spot prices and their impact on Shell’s earnings because of the average tenure of pricing contracts), the recent decline in oil prices could cause its fourth quarter upstream earnings to be as much as $2.4 billion lower, compared to the previous year’s quarter. However, we believe that lower exploration expense and improvement in sales volume-mix will partially offset the impact of lower oil prices on Shell’s upstream earnings. [1]

The key reason behind the steep decline in Shell’s adjusted E&P margins in 2013 was the sharp increase in exploration expense. The company’s exploration expense increased by 70% over 2012 and was more than 136% higher than the average annual exploration expense between 2008 and 2012. This was primarily because the company had to write down costs related to a large number of dry holes in the Americas. However, during the first nine months of 2014, the company’s exploration expense stood at just $2.9 billion, which is almost 17.5% lower than the same period the previous year. Going forward, we expect Shell’s exploration expense to be more normalized as the company has significantly trimmed down its exposure towards more risky acreage as a part of its ongoing divestment program. [2]

Thicker Refining Margins

We expect Shell’s downstream margins to receive a significant boost from thicker refining margins during the fourth quarter, primarily driven by an improved global refining environment and reduced exposure to less profitable downstream assets as a result of the divestment program. Shell has been actively pursuing the divestment of its not-so-profitable downstream assets over the past few years and it plans to continue doing so in the near future in order to increase the profitability of its overall portfolio. Since 2010, the company has generated around $10 billion in proceeds from such transactions. Recent downstream divestments completed by Shell include refinery sales in the U.K., France, Germany, Norway, and Czech Republic. [2]

Most recently, the company announced the sale of its Norwegian marketing assets to Finland’s ST1. As a part of the deal, ST1 will take over Shell’s retail, commercial fuels, and supply and distribution businesses in Norway. In addition, Shell’s aviation business in Norway will become a 50-50 joint venture with ST1. Improvement in refining margins and operating rates boosted Shell’s downstream earnings by $500 million during the third quarter last year, compared to the previous year’s quarter. We expect a similar performance during the fourth quarter as well. [3]

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Notes:
  1. Royal Dutch Shell 2014 Q3 Earnings Call Presentation Transcript, shell.com []
  2. Royal Dutch Shell 2014 Q3 Earnings Call Presentation, shell.com [] []
  3. Shell Agrees Sale Of Some Downstream Businesses In Norway To ST1, shell.com []