Shell Has Best Shale Strategy Of All Oil Majors

Much has been made lately of the deep dive into shale that the likes of oil majors such as Chevron (NYSE:CVX) and Exxon (NYSE:XOM) decided to take in the past few years. A fight over Anadarko (NYSE:APC) between Chevron and Occidental (NYSE:OXY) was perhaps the most emblematic symbol of this industry-changing trend. Analysts and investors quickly jumped to the conclusion that it is imperative for all oil majors to jump in and compete with each other on acquiring and developing shale assets. Exxon and Chevron are currently planning to increase shale production to 1 mb/d each. Shell (NYSE:RDS.A) (NYSE:RDS.B) has been more timid in this regard, and given the profitability profile of the overall shale industry, I am fully satisfied with its position in this regard. Shell’s downstream investments, such as the Pennsylvania ethane plant, meant to take advantage of low shale prices, seems to make far more sense than rushing to produce the low-priced natural gas. Nor does it seem all that wise to rush to produce shale oil, which requires extremely high capital expenses to produce. Some investors may believe that it is more important to maintain reserves and production by diving into the shale patch. I personally think that it is not worth diluting Shell’s overall profitability profile by producing shale oil and gas for the sake of maintaining the company’s overall production numbers.

Shell’s exposure to shale patch is comparatively more limited and so are its future plans

It is reported that Shell is planning to increase shale production to 500,000 b/d by the end of this year. At the same time, it announced this summer that it has no plans to acquire more shale property, because everything on offer is seen as overpriced. This speaks to a clear contrast between Shell’s position and that of Chevron and Occidental, both of which pushed hard to acquire Anadarko and its mostly shale assets. Shell is increasing production from already existing acreage, while its stated intentions in regards to any future purchase is to only do so if and only there is some particular opportunity which would represent a bargain. While there has been much speculation that Shell will follow the example of its peers, it increasingly seems that it is not willing to play along.

Larger shale footprint means higher CAPEX to revenue ratio

Perhaps the main defining characteristic of shale drilling, which sets it aside from conventional oil & gas production, is the very high CAPEX to revenue rates that we see among shale drillers. If we look at diversified oil majors profile in this regard compared with typical shale producers, we find that the difference is huge. It is true that this in large part due to the fact that oil majors have the benefit of legacy downstream operations, which they accumulated over decades, but this is only part of the reason why oil majors, which mostly produce oil from conventional fields have lower CAPEX to revenue ratios compared with their shale peers.

As we can see, the difference in capital spending needs between well-diversified oil majors, with upstream and downstream activities all around the world, and shale drillers is spectacular. It is true that shale drillers were still increasing production last year at a relatively robust pace, while oil majors are seeing mostly stagnated production. It is also true that the downstream segments of the oil majors require little capital spending, given that they’ve spent money on building up their facilities for many decades, which also distorts the true picture in regards to shale versus non-shale upstream CAPEX differences. It is nevertheless a very strong indication in regards to the kind of capital spending oil majors will engage in as they try to replace dwindling conventional production with shale. I do believe that the likes of Exxon and Chevron will see their capital spending needs rise significantly as they will continue to ramp up shale production in coming years.

Maintaining upstream profitability is important

Of the $24.4 billion in earnings that Shell reported for 2018, $6.8 billion came from its upstream sector. We should keep in mind that 2018 was one of the best years in terms of average oil prices since 2014. I doubt that we will see too many similarly good years in the more immediate future, mostly due to poor global economic growth prospects. With its shale production projections showing that it will reach 500,000 b/d in oil equivalent, even if it were to see a hypothetical average loss of about $10/barrel on its shale production any given year, it would amount about $1.83 billion in losses dragging down its overall profitability for the year. Assuming the same amount of loss per barrel for Chevron or Exxon, once they reach their goals to produce about 1 mb/d of shale oil equivalent each, the drag on their finances would obviously be double. For Chevron, such a drag on profits would mean a roughly $3.7 billion hole, which would be significant. I should note that its shale activities are seemingly already causing a drag on its American upstream profits.

Source: Chevron

As we can see, as oil prices improved in 2018 compared with the previous year, international upstream earnings doubled, while US earnings actually declined slightly. It should be noted that its US production is rising while its international production is shrinking.

Source: Chevron

Shell’s US production is dominated by the Gulf of Mexico production, where it gets 54% of its US production from. Shale is still a relatively minor part of its overall US and global production, although it is growing. The US production itself is not as important to Shell’s upstream production as it is for Chevron. US production made up just over 20% of total oil and gas production last year. About a third of Chevron’s oil production comes from the US.

Shell’s continued industry leadership in LNG and petrochemicals remains main reason to be optimistic about its future

A potential trend of declining upstream production in coming years can make for headlines that will lead to negative investor sentiment towards Shell, while other oil majors may get rewarded for being able to use their shale expansion plans to increase overall production. It does not mean however that such a path is a healthy one for the finances of these companies, which is why I am glad as an investor that Shell is not rushing to purchase more shale acreage.

Shell is doing the things which I highlighted in the past as being of paramount importance, such as continuing to grow its already industry-leading LNG segment. LNG shipments grew to 34.3 million tonnes last year, up from 30.9 million tonnes in 2016. That volume represents almost 11% of global LNG production. Given the growing desire of countries around the world to replace coal with cleaner-burning natural gas, natural gas demand is set to continue to grow significantly. In order to improve supply security, most major economies are looking at satisfying their natural gas needs at least partially through LNG imports. LNG is more expensive than pipeline gas in most parts of the world, but the development of LNG import capacity does provide added supply flexibility, since the gas does not depend on pipelines that often take years to build.

The Pennsylvania ethane plant is a clear example of Shell’s logic when it comes to its shale approach. US natural gas prices are currently very low. In fact, they are so low that many shale producers are losing money. The Appalachian region in particular is seeing very low natural gas prices, because of a regional glut. This alone makes Shell’s petrochemical plant more profitable than most similar operations around the world. Investment moves such as this one are what makes Shell such an attractive company to invest in. It has been the largest holding in my portfolio for a few years now, and for now, I see no reason to change it.

Disclosure: I am/we are long RDS.A, CVX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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