Shell Profits Warning – The Shock That Wasn't

By: Andrew_McKillop

New CEO Admits : Shell's new CEO Ben van Beurden has admitted corporate performance in 2013 was not what he expected from the group. Just two weeks after taking over the helm at end-December, he gave what journalists and commentators called “a shock profit warning”, saying that full-year profits excluding “special items” could be about 25% below 2012's performance. For the 4th Quarter of 2013 Shell's earnings before special items fell by about 50%.

In a mix and mingle of rational and strange explanations, while distancing himself as the “New Man” from what happened under previous CEO Peter Voser, the new CEO firstly blamed lower oil and gas prices, which for oil is a strange claim. He went on to widen his claims by saying that Shell is exposed to "weak industry conditions" in downstream oil, unexpected costs in its drive to become the most natural gas-oriented of the oil majors, higher exploration and infrastructure expenses, higher corporate risks, especially in Iraq, and lower upstream production volumes.

The group's third- and fourth-quarter 2013 earnings figures were badly hit by a 3Q 49% drop in downstream profits, blamed on adverse refining conditions, both in North America but especially in Europe, due to structural refining overcapacity and weak energy demand. Van Beurden also cited the huge upstream asset writedowns made in 2013.

Shell was quickly accused by some analysts of “kitchen sinking”, that is rushing to pump out the bad news, hoping investors will think the worst is over and past.

Van Beurden said these special items ran at  $700m for 4Q 2013, and at $2.7bn for the full year. When these massive writedowns, which will continue through 2014 are included in 2013 corporate figures, fourth-quarter earnings will be about 70% lower than one year before. Full year 2013 earnings, at about $16.75bn will be down by around 38% compared with 2012.

Despite Shell issuing its first-ever profits warning in more than 10 years, next day trading on 17 January only clipped its share price by about 3%. This was in part due to van Beurden's frequent references to his drive for “better capital efficiency”, which for analysts and major investors has to mean Shell will cut back on its runaway capex (capital expenditure) program. This spending in 2013 racked up a total of $44bn, compared with total corporate turnover of $40.3bn.

Shell and the Gas Bubble

In early November 2012 at London's Royal Institution, outgoing CEO Voser hammered the “go for gas” strategy Shell has pursued since the 1990s. He argued that Shell – as an integrated energy major – is creating value from the whole production supply chain, and the corporation sets gas growth as the jewel in the crown. He defended the gas strategy with the argument that sustained investment through the implied oil-gas value cycle is what shareholders want, not a stop-start strategy. Voser also repeated the corporate conviction that investment in gas exploration, production, processing and supply were “30-year assets”, and Shell was not in the business of chasing “short-term volume targets or market share”.

From before Voser’s time as CEO, and almost certainly through new CEO van Beuren's watch, Shell has a few fixed or recurring corporate traumas, starting with the fear Europe will be left behind in the global dash for gas, becoming a continent completely reliant on volatile imports, while the rest of the world races towards gas self-sufficiency. Shell strategists believe Europe's decreasing domestic gas production is structural – due to policy if not geology – and the continent now has a stark choice between importing more gas or allowing shale gas to be developed.

In his early November presentation to London's Royal Society, ex-CEO Voser repeated another fixed belief of Shell's corporate strategists. They imagine gas demand is growing so fast in Europe the continent may be left behind for signing up a share of future gas production among the worldwide flurry of new stranded gas finds and shale gas development.

Voser was simply talking about reality when he signalled the massive rate of global gas finds, and extended reserve revisions as gas E&P progresses, with huge finds or reserve extensions since 2009 in countries as wide ranging as Mozambique, Tanzania, Azerbaijan, Iraq, Australia, Qatar, Iran, Brazil and elsewhere. But his claim that European gas demand is on a tear is light years from reality. European gas demand is falling. Growth potential for gas in Europe is at best modest.

Worse still for Shell, global gas demand growth has repeatedly failed its major economic challenge – that is the expectation, or gas producers' hope that consumption will increase despite slowing economic growth, reduced industrial output and outplacement, cheap coal supplies, the renewables, energy saving, and several other demand-trimming factors. Gas failed this challenge. Teflon-style growth of global gas demand is no longer the case, even if it held previously.

Shell's corporate policy statements and reviews on its dash for gas are now at best “forward looking statements”, based on the energy world before at latest 2012. Investors may want to more carefully scrutinize these assertions and claims, today.

Two specific gas sectors are easily identified as creating the most serious challenges for Shell on the downstream side, GTL or gas to liquids conversion, and gas-fired power production in a few large markets, especially Europe and Japan. On the upstream side, as partly-admitted by van Beuren, the scramble for gas drilling acreages, and the following serial increase of development costs often generating veritable capex explosions, and nearly always stretched completion schedules which sometimes double the number of years needed, has made many attractive prospects turn very sour.

Divest and Survive

Runaway capex, stretched project schedules, declining or stagnant oil and gas market outlooks, and increasing country risk in key operating countries are among the reasons Shell has been forced into a very active divestment program. It is estimated by some analysts as possibly running to 30 billion dollars through 2012-2015.

Official divestment goals as announced by new CEO van Beuren are for sales of assets able to raise $15 billion over 2 years. Already known to some journalists and analysts, this will inevitably target “mature upstream assets”, especially in the now capex-intensive “drilled out” North Sea and a large slice of Shell's refining portfolio in Europe and the US. Some of this concerns non-performing assets which are likely to stay that way, unless huge new capex is thrown at the problem.

More important for Shell's gas strategy, corporate triage will winnow out  a lengthening list of projects moving up the investment decision ladder, that are now considered too risky or overpriced – at the same time as corporate spokespersons have said there is no question of Shell reducing its goal of $130 bn of capex spending through 2012-2015. Project triage, due to the urgency of reducing Shell's runaway spending profile, may well extend from project types with a probable continuation of Shell's retreat from refining and oil production, to a complete retreat from selected large geographic regions. Analysts suggest the first to be abandoned by Shell may be Australia and West Africa, particularly Nigeria. But a near-total retreat from the North Sea production and European refining is also not impossible.

Contradicting corporate confidence in a shining near-term future for gas, Shell is also cutting back its US shale gas operations. It said in September that it was selling its acreages and production shares in the large Eagle Ford and smaller Mississippi Lime shale zones. The corporation has also shelved or delayed prospective agreements for LNG gas transport and terminals development with US, Canadian and international energy partners.

Corporate capex triage, in part due to unexpectedly long project development schedules and high costs in the gas sector, has focused Shell to higher risk projects offering higher possible returns. These particularly concern Iraq, where Shell is focusing oil, gas and petrochemicals development.

In mid-November, ex-CEO Voser announced that Shell and the Iraqi government were close to cementing a deal to build an $11 billion petrochemical complex named Nebras in southern Iraq in what will be biggest move by Shell in Iraq's energy sector. The project inevitably carries large and increasing country risk. The Nebras project may be used by the Nouri al-Maliki government in Baghdad as a bargaining chip in the lengthening number of disputes that it has with Shell, and the other majors operating in Iraq on revenue sharing, production increases, infrastructure spending and other issues. .

The Shock that Was Not A Surprise

Shell cannot be wrongfooted for its corporate conviction that global gas had to grow. Among the oil majors, it is now the most gas-intensive producer and has global reach in gas reserves, transport and downstream assets, and value-add through gas-based petrochemicals. Shell is also a world leader in GTL (gas to liquids) conversion. Its Malaysian Bintula plant, opened in 1993, is a model for this conversion technology, now upstaged by the Shell-Qatar joint venture Pearl GTL project, the biggest GTL producer in the world.

This can be called the good news. Its Bintula GTL plant, for which simply repairs to a major accident in 1997 cost about $1 billion, produces about 17 000 barrels a day of a range of fuel and nonfuel liquids, pricing this technology into a special cost dimension utterly dependent on almost-free natural gas for breakeven. The same applies to the Pearl GTL venture. If the gas is free, GTL works.

As Shell has found, literally to its cost, LNG ventures have a troubling habit of massive cost overruns and stretched completion schedules. Reasons why the corporation may wind down and divest its Australian production operations are summarized by the three-letter word LNG.

Among non-American oil majors, Shell was fast off the block in moving into US shale gas production, but as Exxon Mobil through its gas subsidiary XTO Energy, as well as the USA's biggest gas producer Chesapeake Corp quickly found, along with other producers like Shell, the US shale bonanza can leave a lot of red on company balance sheets. Overall, US gas is too cheap, but Royal Dutch Shell can do nothing about it.

Shell's capex spending spree sprang from a pre-2012 optimistic look at world energy to 2020, in which gas “had to grow”, which it will but at a slower rate, and not in the way Shell hoped. Corporate project planning and management also suffered from the worst kinds of over-optimism, as one example resulting in Shell's new and risky bet on Iraq, which by supreme irony has made strident demands for Shell to increase its gas production in the country!

Perhaps not surprising for an oil major with a European HQ, Shell's focus on Europe has repeatedly produced over-optimistic and irrational corporate forecasts of energy demand recovery in Europe, led by gas, followed by project decisions on that wrongheaded basis. Corporate reading of Europe's energy transition plans believed firstly that emissions trading would hold up giving an edge to gas-fired power production, and that European refining infrastructures would get major and sustained EU and member state support for critically needed makeovers and restructuring. None of this happened in the real world.

Shell's supposedly “shocking” admission its profits will be low for several years – many analysts cite 2017 as the year when the “annus horribilis” will end – cannot be treated as surprising. This was above all a disaster waiting to happen, and it happened.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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