Shell has been one of the best-performing investments in the FTSE 100 over the past three years. Including dividends, the stock has returned 28% per annum, compared to 11.8% for the blue-chip index since mid-2020.
The company has benefited from surging oil and gas prices, following Russia’s invasion of Ukraine at the beginning of 2022, although that’s not the only factor. The pandemic crushed demand for oil and gas, but when the economy reopened, production could not keep up with demand and prices jumped.
Today, we are still seeing the impact of this sudden jump in demand, as well as the impact on the market from Russia’s warmongering.
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Shell’s fortunes start to turn
Sadly, for Shell’s investors, it looks as if the run of bumper earnings is coming to an end. The group reported its lowest quarterly profit in almost two years today after oil and gas prices fell. More importantly, refining profit margins also slumped and this arm has been a key profit engine for the group - Shell is one of Europe’s largest hydrocarbon refiners and oil traders.
The company reported adjusted earnings of $5.1 billion for the second quarter, below analyst expectations of $5.6 billion. In comparison, in the second quarter of 2022, Shell generated earnings of $11.5 billion.
These results illustrate the challenge the company and its investors face. Oil and gas is a highly cyclical and risky business. There are many different factors which go into pricing hydrocarbons and no single producer has any impact on the market price.
And I’m not just talking about oil and gas here. I’m also talking about refined products. All of these markets are global and hypercompetitive, meaning no one business can take advantage to try and earn consistently higher profits.
This is the reason why I think Shell will always trade at a discount to the rest of the market.
Based on current projections, the stock is trading at a forward price-to-earnings (p/e) multiple of 7.3 according to Refinitiv analyst estimates. That looks attractive. However, if oil and gas prices fall in the second half of the year company will have to make do with lower earnings. Then the lower multiple won’t look so outrageous.
Still, where the company can make decisions to boost its profits and cash flows it is. It has revealed plans to reduce capital spending from a range of $23 billion to $27 billion dollars down to $23 billion dollars to $26 billion dollars, it has also laid out plans to reduce costs from operations to improve profit margins.
Cash flow boost for shareholders
The company has made substantial strides in reducing its debt over the past couple of years, using extraordinary profits to pay off credit or obligations. Net debt has fallen from $78 billion at the end of 2019 to $40 billion at the end of June 2023. With interest rates spiking, it looks as if this was the right decision and should save the company billions of dollars in interest payments.
The group has also been using its windfall to reward shareholders. It increased its quarterly dividend by 15% for the second quarter of 2023 and has committed to repurchase $3 billion in shares by the end of October. Over the past 18 months, the group distributed $26 billion to shareholders representing almost 10% of its market value through a combination of dividends and share repurchases. The stock offers a dividend yield of 4.6% today.
The bottom line
So what does this all mean for investors? The numbers clearly show this is a cyclical business where earnings can jump up and down. Shell has made a lot of money over the past two or three years, and it has used this cash wisely, but it’s unclear if the company will be able to repeat this performance as its future will be determined by the state of the global oil market.
That’s something investors need to keep in mind if they’re considering adding this stock to their portfolio.
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