Shell unveils record profits, but should investors back the oil giant?

Oil giant Shell reported record profits of $9.1bn for the first three months of the year and has distributed billions to shareholders. Should you buy in? Rupert Hargreaves investigates.

After BP (LSE: BP) reported its highest quarterly profit in decades earlier this week, Shell (LSE: SHEL) has now followed suit. 

The company’s adjusted profits for the first three months of 2022 hit $9.1bn on an adjusted basis, an all time high and almost three times higher than the figure reported last year. 

Shell’s size is a huge competitive advantage

Shell is Europe’s largest oil company, but it is also the world’s largest trader of liquefied natural gas (LNG) and a big trader of oil. In some respects, these trading businesses are far more important for the enterprise than its production (or upstream) division. 

Commodity trading requires huge amounts of capital and it’s a tough business to get into, but once operators get into this exclusive club, profits can be enormous. 

Shell’s position as both one of the world’s largest oil producers and traders puts it in a unique position, and it has been able to take advantage of this edge in 2022. 

As Europe has rushed to reduce its dependence on Russian gas, demand for the commodity has jumped and prices have responded, more than doubling over the past year. Shell has been able to capitalise on this volatility. In the first quarter, it produced eight million tonnes of LNG and sold 18.3 million tonnes, trading cargoes across the market to meet increasing demand. 

The trading business brings a degree of stability into Shell’s business model. Even if oil prices collapse, the firm will still be able to trade the commodity and make a margin on each deal. In the second quarter of 2020, when the pandemic sent the price of oil into a tailspin, Shell’s upstream business lost $1.5bn. However, its trading and marketing business earned $900m. 

While buying and selling hydrocarbons is a key part of Shell’s business model, the upstream business is currently generating the bulk of its earnings. Oil production and integrated gas divisions generated $4.1bn and $3.5bn in adjusted earnings respectively during the quarter.

Shell’s decision to divest its Russia business incurred post-tax charges of $3.9bn.  

These results showcase the strengths of the integrated Big Oil business model. I think they also show why these companies may have an edge when it comes to managing the green energy transition. 

Shell starts to plan for the next generation

Shell has outlined plans to spend between $2bn and $3bn a year on low-carbon investments and technologies. While this is a fraction of the $20bn+ it is spending every year on capital projects overall, it does make Shell one of the biggest spenders on green projects in the FTSE 100. In comparison, utility provider SSE (LSE: SSE) , one of the UK’s largest renewables investors, is spending around $3.2bn a year over the next five years.

Management has acknowledged that oil and gas will continue to play a role in the global energy system for decades to come, and it is trying to balance green spending with hydrocarbon investment. Only time will tell if this is the right strategy, but so far, Shell’s decision to follow this course seems sensible. 

Shell’s legacy hydrocarbon business is throwing off cash, freeing up capital for it to invest in new projects, reduce debt and return cash to shareholders. 

This last point might be the most important. In a world of rising interest rates, gnawing inflation and growing economic uncertainty, investors are no longer willing to pay nose-bleed multiples of sales for unprofitable, speculative businesses. As these companies crash back to earth, it is becoming harder for them to raise the money needed to keep the lights on. 

Shell does not need to worry about raising new capital from investors, it is generating plenty of that, which means it can (to a certain extent) chart its own course. And by returning large amounts of money to shareholders, it can keep investors sweet and follow its own path. 

Impressive shareholder returns 

During the first quarter of 2022, total shareholder distributions amounted to $5.4bn and net debt fell from $52.6bn to $48.5bn. There are further cash returns to come. Shell has only completed $4bn of its $8.5bn share buyback programme and increased its quarterly dividend by 4%. The shares are on track to yield 3.7% this year, according to estimates by Refinitiv, a financial data company. 

Some supporters of ESG investing might argue that Shell has got it wrong; that it should stop all oil and gas activities and invest all of its cash in green energy. As we’ve seen over the past couple of months, while the world is making progress in moving away from fossil fuels, it is nowhere near the point where it can rely on green energy to meet all of its energy needs. 

By trying to strike the right balance between investments in different energy systems, Shell offers investors the best of both worlds – exposure to green energy with the stability of cash flows from legacy hydrocarbon assets. 

The stock also looks cheap at current levels. It is dealing at a forward price/earnings (p/e) ratio of 6.1 compared to the market average of around 13. 

Still, as I have noted before, while Shell and its peer BP are currently generating bumper profits, this is unlikely to last. There are already some signs that the oil and gas market is responding to higher prices by increasing output. This could drive oversupply if global demand slows in the months and years ahead. And if profits start to slide, it’s shareholder returns that will suffer over capital spending. 

So, Shell seems to be moving in the right direction today, but investors need to keep the risks of investing in the oil and gas sector in mind. Shell could be a great investment to own in today’s uncertain world, but current tailwinds may not last forever. 

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