Shell Offers Differentiated Energy Transition Plan, but This Could Change

Strategist

Allen Good

Shell’s latest strategic plan to adapt to the energy transition and achieve its target of a net-zero portfolio by 2050 is similar to peers' but different in an important way. Like peers with similar targets and goals, Shell plans to expand its marketing retail operations and reduce oil production over time, but unlike peers, Shell has refrained from offering up an explicit renewable generation capacity target. Given the competitiveness of the space and the potential for lower returns as more firms enter the space, this is likely prudent.

Instead, Shell plans to focus more on the customer, which is where it believes the value will be in the energy transition, as opposed to the asset. Instead of producing large amounts of renewable power, it will work with customers that want to secure low-carbon solutions for their businesses. This will result in Shell producing some renewable power as well as expanding further into low-carbon fuels such as hydrogen and biofuels while leveraging its trading operations to secure additional supplies. Management believes participating along the entire low-carbon energy spectrum will prove difficult to replicate and produce a competitive advantage. It calls this solution power as a service, looking to capitalize on the other "as a service" business model the market is fond of.

In the near term, the new Shell will look more like the current Shell. Although cash flow generation over time will be less sensitive to commodity prices, the upstream and integrated gas and chemicals and products businesses will still contribute 75% of operating cash flow by 2025, according to Shell.

This strategy is subject to change, however, given several changes since it was announced. Despite recent court cases ordering Shell to reduce emissions beyond its existing targets, a new management team might look to reverse or slow plans to move away from oil production, given a valuation discount and a different outlook for oil markets in the wake of Russia's invasion of Ukraine. We have already seen such an announcement by BP and wouldn't be surprised to see Shell follow suit at its next strategic update.

Business Strategy & Outlook

We do not think Shell earns an economic moat rating. Our forecast for excess returns has become too low while the company’s future uncertainty is too high to award a moat. 

Shell has made significant headway in reducing operating costs in its existing production base and capital intensity of new projects, so we forecast it could earn adequate excess returns at our midcycle price assumption of $60 a barrel. However, the uncertainty of excess returns 10 years from now has increased due to the changing composition of the business and potential level of commodity prices during the next 10 years. We don't have the confidence that Shell’s plan to transition to a more renewable and low-carbon business will create competitive advantages or that commodity prices will be consistently at levels sufficient to generate excess returns during the next 10 years. As such, Shell fails to meet key criteria for our narrow economic moat rating. As time passes and Shell demonstrates a high level of competence and execution in these newer areas, or our view changes on commodity prices, we could revise our moat rating.

Historically, our evaluation of Shell’s moat was based on the low-cost position of its oil and gas assets. However, incremental investment is increasingly going to other areas that are less likely to earn a moat, in our view, or whose outlook is uncertain. Investment levels will center on the latest organizational iteration of its business units into three pillars: growth, which includes marketing and renewable and energy solutions; transition, which includes integrated gas and chemicals and products; and upstream. Initially, upstream will command about 35%-40% of total spending but that will fall to 25%-30% beyond 2025. The transition pillar will garner 35%-40% of spending initially but will fall to 30%-40% beyond 2025. Investment in the growth pillar will grow from 25% currently to 25%-40% beyond 2025 so that it generates roughly 25% of cash flow by then as well.

Shell has improved the cost position of its upstream segment including existing production and new projects. During the last five years Shell has reduced unit development cost and operating cost by 51% and 26%, respectively. Operating costs would likely have fallen further were it not for production impacts from the pandemic in 2020. It aspires to another 10% reduction in development costs and 20%-30% reduction in operating costs by 2025. It has also reduced and focused investment on the highest-quality assets. According to Shell, its slate of new projects should be returns accretive with anticipated average returns of 20%-25%, an average breakeven price of $30/bbl, and an average payback period of seven years. Based on Rystad data, we estimate Shell’s project queue (sanctioned and unsanctioned) has an average breakeven price of $42/bbl, well below our assumed midcycle price of $60/bbl. 

Although this would imply that Shell can safely deliver incremental excess returns, the last decade or so has left us wary. Including the crash in 2008, oil prices have crashed three times. While they quickly rebounded to $100/bbl by 2010, they subsequently crashed again in 2014 due to the oversupply from the emergence of light tight oil in the U.S. This also represented a permanent downward shift in the cost curve as well and led to the revision of our midcycle price to $60/bbl. As a result of this volatility, Shell’s cumulative economic profit from 2011 to 2019 was minimal. In 2020, the coronavirus pandemic caused another oil price crash, which we estimate will result in a negative cumulative economic profit during the next five years even as prices have recovered and the improvement in Shell’s cost structure holds. 

Given the oil price volatility of the last decade, the emergence of U.S. light tight oil, which acts as the global marginal supplier that can quickly ramp up or down, and the uncertainty of demand (coronavirus fallout, work-from-home impact, electric vehicle penetration, and so on), we think it is reasonable to expect similar volatility during the next decade. This does not imply prices can only fall. To be sure, the fallout from currently low prices is also industry underinvestment that could ultimately result in a global shortage and much higher prices than our $60/bbl assumption. Regardless, the excess returns we forecast for Shell at our midcycle price are too narrow to instill the necessary confidence they can endure through the cycle in a variety of price environments; thus our no-moat rating. Our revision to our midcycle price assumption could prompt a change in the moat rating if excess returns are sufficient. 

Additionally, oil production for Shell has peaked and will fall 1%-2% per year through 2030 through natural decline and divestitures, implying about a 15% total reduction in volumes, reducing the impact of the upstream segment’s improved cost position and incremental higher returns on total company returns over time. By Shell’s estimates, the upstream segment will only contribute about 30% of cash flow beyond 2025, meaning its influence on the company's competitive position and our moat rating will wane over time. 

Although likely to generate lower incremental returns than the upstream businesses, much of the company’s cash flow will still come from legacy businesses within Shell’s core competency. These businesses include integrated gas (primarily liquefied natural gas), chemicals and products (refining), and marketing, which all arguably have stronger long-term demand outlooks than oil. Only renewables and energy solutions mark new territory and hold greater uncertainty. 

Through its integrated gas segment, Shell holds the largest LNG portfolio amongst peers with 70 million tons per annum in LNG sales volumes in 2020, including 33 mtpa of its own production. Although returns have been uneven for this segment the last four years and are weighed down by past high-cost and capital-intensive projects, new projects should be returns-accretive. Shell plans to bring on another 7 mtpa of capacity by the middle of the decade, which should benefit from a decline in LNG technical cost (capital and operating) per million Btu of 40% since 2015 and should deliver returns of 14%-18%. Meanwhile, the long-term outlook for gas demand remains favorable, with most third-party forecasters calling for continued demand growth, given emissions savings from substitution of coal in power generation, the need to supplement intermittent renewable power generation, and expanding applications in shipping and road transport. Finally, prices for Shell’s integrated gas production are primarily tied to global crude benchmarks, which results in higher prices than typical pipeline gas pricing. 

We view the legacy chemical and oil products business (refining) in a similar light as Shell is investing in what it knows. Returns for both segments have suffered from weak market margins the last several years but should improve in the future. Shell plans to reduce its refining footprint to six core facilities that produce both refined products and chemicals that typically deliver higher returns, given lower costs and greater flexibility among feedstocks and final products. Given the stronger demand outlook for chemicals relative to refined products and lower emissions, it also plans to reduce fuel production at these sites and increase production of higher-value performance and intermediate chemicals. The elimination of higher-cost and lower-return facilities as well as the mix shift toward chemicals should improve returns in the segment. 

As part of its growth plan, Shell plans to invest in its marketing business. Although this is a legacy business with a record of strong returns, we think its outlook is uncertain. Shell’s plan calls for growth in its branded service stations, convenience stores, and EV charging points and market share growth for its lubricants business to increase earnings 50% by 2025. The plan calls for combining EV charging and improved convenience options to drive traffic through its retail sites in a lower-carbon world. This plan has risk, in our view. Unlike an internal combustion engine, where drivers have only one option (gas stations) to refuel, EV owners will potentially have multiple options including at home, work, and other retail locations such as shopping malls. It's unclear why an EV owner would need to go to a Shell station to charge outside a long-distance trip. As such, already tenuous switching costs will seem to weaken further. Furthermore, EV chargers distribute relatively little energy and operate at low utilization rates, likely making them a poor earnings substitute for selling gasoline. An increasing number of delivery options for groceries might threaten the demand for enhanced offerings at retail locations. 

The final element of Shell's new strategy is focused on renewables and energy solutions. This a relatively new business started in 2016; it currently serves more than 1 million residential and small-business customers primarily in Europe and more than 10,000 commercial and industrial customers. Shell is striving to differentiate its strategy as a service, leveraging its trading experience to provide clean power to clients looking to decarbonize, as opposed to just investing directly in renewable power generation assets. Although it will do that as well, it does not have a specific target as many peers do. It aims to deliver 10% unleveraged returns and grow to over 15 million customers by 2030 so that it becomes a material business for Shell. The strategy does capitalize on Shell’s brand and experience such as trading likely delivers steady, excess returns through an asset-light model. However, it’s unclear if Shell can truly differentiate itself from peers and other market entrants, where it is adding value, and how it will extract or generate greater economic rents in what is essentially a commodity distribution business. As more players enter the space, returns are likely to come under pressure. Plans to invest in and expand its hydrogen and carbon capture business hold promise and also the potential for a cost advantage, but are highly uncertain as well. The overall uncertainty of the renewable strategy and industry keeps us from calling it moatworthy at this time. 

Shell is exposed to several environmental, social, and governance-related risks, but these have no bearing on our final moat rating as most are too long-term for moat consideration or are not probable or material enough risk to cause material value destruction. Shell’s primary ESG risk stems from carbon emissions in its operations and use of its products and emissions, effluents, and waste generated in operations such as oil spills. 

The risk from carbon emissions is most likely to materialize through a carbon tax that increases the price of end products to consumers, reducing demand over time and threatening Shell’s hydrocarbon business. We expect carbon taxes to gain greater adoption over time but think the impact on hydrocarbon demand remains more than a decade away. Furthermore, Shell’s strategic plans call for a gradual move away from hydrocarbons, which is designed to reduce the firm’s carbon intensity by 20% in 2030 and 45% in 2035, and that should further insulate it from the impact of a carbon tax. Additionally, Shell recently set an intermediate absolute emissions reduction target of 50% by 2030, compared with net 2016 levels that will cover scope 1 and 2 emissions under operational control.

Oil spills are an ever-present risk for oil companies operating offshore and can be devastating to firm value, as BP’s Macondo incident in the Gulf of Mexico shows. While oil companies regularly cause spills, most are immaterial in size and associated fines and cleanup costs are manageable. Meanwhile, large spills such as Macondo are very rare and do not factor into any of our scenario modeling. Most of Shell’s spills occur in onshore Nigeria, where 90% are due to sabotage from the local population. Shell has improved its spill response there but is looking at potentially divesting these assets.

None

Economic Moat

Shell PLC

Shell Plc engages the production of oil and natural gas. It operates through the following segments: Integrated Gas, Upstream, Oil Products, Chemicals, and Corporate. The Integrated Gas segment includes the liquefied natural gas, conversion of natural gas into gas to liquid fuels and other products, and new energies portfolio. The Upstream segment explores and extracts crude oil, natural gas, and natural gas liquids. The Oil Products segment is involved in refining and trading, and marketing classes of business. The Chemicals segment manages manufacturing plants and its own marketing network. The Corporate segment consists of holdings and treasury, self-insurance activities, and headquarters and central functions. The company was founded in February 1907 and is headquartered in London, the United Kingdom.

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Transaction in Own Shares June 02, 2023 • • • • • • • • • • • • • • • • Shell plc (the 'Company') announces that on 02 June 2023 it purchased the following number of Shares for cancellation. Aggregated information on Shares purchased according to trading venue: Date of Purchase Number of Shares purchased Highest price paid Lowest price paid Volume weighted average price paid per share Venue Currency 02/06/2023 531,424 £ 22.9300 £ 22.6300 £ 22.8194 LSE GBP 02/06/2023 - - - - Chi-X (CXE) GBP 02/06/2023 - - - - BATS (BXE) GBP 02/06/2023 653,375 € 27.0750 € 26.6950 € 26.9206 XAMS EUR 02/06/2023 - - - - CBOE DXE EUR 02/06/2023 - - - - TQEX EUR These share purchases form part of the on- and off-market limbs of the Company's existing share buy-back programme previously announced on 4 May 2023.

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