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On Feb 27, Zacks Investment Research downgraded Europe’s largest oil company Royal Dutch Shell plc (RDS.A - Analyst Report) to a Zacks Rank #5 (Strong Sell).

Why the Downgrade?

Following Shell’s weak fourth-quarter results, we see the integrated player as a risky bet that ordinary investors should exit.

Detailed Analysis

The Hague-based Shell recently reported weak fourth quarter 2013 results due to high costs, lower output, supply disruptions in Nigeria and a drop in refining margin.

Upstream segment earnings during the quarter were down 43.7% on the back of lower liquids realizations, higher exploration expenses, increased operating costs, more number of maintenance projects, together with output hurdles in Nigeria. On the other hand, lower refining profitability (particularly in Asia and Europe), coupled with weak marketing and trading contributions, halved downstream earnings.

In particular, we remain concerned about Shell’s relatively heavy downstream exposure, which leaves it less diversified than its integrated peers. As such, the group’s results remain greatly exposed to refining/marketing margins. Shell’s downstream operations have struggled recently due to weak demand for fuel, leading to lower returns in this segment.

As usual, we remain worried about Shell being the most gas-focused among the major companies in the sector, with more than half of its current production from the commodity. Given natural gas’ volatile fundamentals, this remains a key area of concern, in our view.

Finally, Shell projects investment of more than $40 billion in 2014, quite high by industry standards. This is expected to substantially increase the group’s leverage and deteriorate its credit metrics during the current downturn. Additionally, the increasing capital intensity of its operations may result in reduced returns going forward.   

Stocks That Warrant a Look

While we expect Shell to perform below its peers and industry levels in the coming months and see little reason for investors to own the stock, one can look at Patterson-UTI Energy Inc. (PTEN - Analyst Report), Helmerich & Payne Inc. (HP - Analyst Report) and New Source Energy Partners L.P. (NSLP - Snapshot Report). These oil and gas drillers – sporting a Zacks Rank #1 (Strong Buy) – have recorded solid growth and have the potential to rise significantly from the current levels.

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