It strikes me that one of the best sources of value right now is in the energy space. As much as I’d like to buy heaps of Coca-Cola, PepsiCo and McDonald’s stock (among others) their valuations are pushing way beyond historical norms. The energy sector, on the other hand, offers up some good bargains.
Take Royal Dutch Shell (NYSE: RDS.A, RDS.B) as a case in point. Right now you can buy Shell ADRs on the New York Stock Exchange for around $64 apiece. As a general rule of thumb energy stocks that look ‘cheap’ during periods of average (or even low) commodity prices are usually decent value. With that in mind the current $60 oil price environment, which I’d classify as pretty average, should act as a useful yardstick.
For example in Q1 2019 the company reported net profit of $5.3 billion ($1.30 per ADR) at an average Brent oil price of $63 per barrel. If Shell can make $5.20 per ADR in that kind of price environment then the stock’s associated valuation – around 12x annual earnings – is probably legitimately attractive.
Shell: The 2025 Shareholder Return Outlook
I make that claim based partly on what the company has planned over the next six-and-a-half years. In a nutshell Shell is going to returns gobs of cash to stockholders. If my sums are correct then the total bill will come to $145 billion over the next six-and-a-half years. The current annual dividend ($3.76 per ADR) costs the company around $15 billion per year, so the ‘extra’ cash going to shareholders amounts to about $7.5 billion per year. It will come in two parts. First, we have the ongoing $25 billion stock buyback program which kicked off in 2018. To date Shell has spent around $6.2 billion, so call it another $18.8 billion before the end of next year.
The second phase kicks off in 2021 and runs through to the end of 2025. During this period the company says it will return a total of $125 billion to shareholders by way of dividends and additional share repurchases. According to management total cash spent on dividends is actually expected to go down, while the per-share dividend is expected to go up. The only way that happens is via more mammoth share repurchase programs.
What does this mean for stockholders? Well, as it stands Shell’s current market capitalization is around $250 billion. The company is returning over half of that to shareholders through 2025. Call that an annual figure of around 9% spread out over six-and-a-half years. If that sounds too good to be true then it probably shouldn’t. Remember Shell’s current earnings yield is already approaching 9%, so in a roundabout way what we basically have is the company saying that it plans to return all of its profit to shareholders.
Some other things to consider. First, it looks like we are about to annihilate the 1.5 billion extra shares that were created to fund the BG Group acquisition back in 2015. Shell has already retired 195 million shares, so call it a further 1.3 billion to fully offset that dilution. Based on the current share price that is certainly doable by the mid-2020s.
Second, a lot of folks are worried that Shell is scrimping on CapEx in order to achieve this. For a company that plans to invest $30 billion a year that might seem an odd charge, but there is a certain logic to this. You see at the end of 2016 the company had total proved reserves of 13.25 billion barrels of oil equivalent. Average production at the time was around 3.66 million barrels per day. Plugging the latter figure into the former gives us around a decade of production life.
Since then Shell has been fairly busy in offloading producing assets in order to raise cash. By the end of last year total proved reserves had fallen to 11.5 billion barrels of oil equivalent. Average daily production was around the same as back in 2016. The upshot: the company’s proved reserves life has dropped to eight-and-a-half years.
On the face of it you can see why that might be an issue. After all, if oil and gas companies don’t replace their reserves then where will future revenue and profit come from? There are a couple of mitigating factors here. Firstly, the reserves that have been ‘lost’ typically represents less profitable production. Back in 2016 it cost Shell $10.92 to pull each barrel of oil equivalent from the ground. Last year it cost just $9.66. By my count that is worth $1.75 billion to the bottom line.
Secondly, Shell’s profit mix is undergoing a significant change. For instance by 2025 it expects to generate around $3.5 billion in post-CapEx free cash flow from its Chemicals segment. That is around 9x more than it generated last year. Management also expects the Oil Products segment – refining crude into lubricants, gasoline, jet fuel and so on – to generate free cash flow of $8.5 billion by 2025, up from $6.3 billion last year. If we take those numbers at face value then we are looking at an extra $5.5 billion per year from segments that are less closely linked to the reserves life of its oil and gas assets.
As a final brief thought it is worth remembering how good a performer Shell stock was in the past. The recipe for that was a simple one: high earnings yield, large shareholder returns, and modest growth. If Shell can execute its strategy then the next few years appear to offer more of the same.