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Hold onto Royal Dutch Shell

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On Aug 21, 2013, we retained our Neutral recommendation on Europe’s largest oil company Royal Dutch Shell plc (RDS.A - Free Report) .

Why the Reiteration?

Royal Dutch Shell is one of the largest integrated energy firms in the world with a strong and diversified portfolio of development projects that offer attractive long-term opportunities.  The group – renowned for its success in bringing some of the largest and most technically challenging capital-intensive projects to fruition – is expected to continue accelerating revenue and earnings growth over the next few quarters. A healthy dividend yield and reasonably cheap valuation are other positives in the Shell story.

However, the company is particularly susceptible to its high exposure to the downstream business, as well as its major natural gas focus and lofty capital spending.  

Detailed Analysis

Royal Dutch Shell has outlined plans to boost its focus on the more lucrative and well performing ‘upstream’ exploration and production end of the business. The group expects annual worldwide production to increase some 20% by 2017-2018 (from 2012 levels), driven by a new wave of project startups. Shell’s targeted output advance represents one of the most ambitious growth programs in the sector, which will be achieved primarily by new projects coming onstream in Qatar, Australia and North America. The company currently has approximately 30 projects under construction that should guarantee upstream growth for years to come.

Of particular significance is the group’s leading position in natural gas. Royal Dutch Shell is the second largest natural gas producer in the world. It has led its super major peers in monetizing its substantial worldwide equity natural gas resource base by investing in liquefied natural gas (LNG) and Gas-to-Liquids (GtL) technologies. Shell has been a frontrunner in the LNG and GtL spaces, backed by years of research and development, extensive expertise, multi-billion dollar investments and cordial relationships with partners/governments worldwide.  

Royal Dutch Shell’s current dividend, while providing a healthy yield of some 6%, caps the payout ratio around a very manageable 45%. Importantly, the cash-rich company – which last year raised its payout for the first time since 2009 – has done the same for 2013 as well.

However, as is the case with other companies engaged in the business of exploration and production, Shell’s results are directly exposed to oil and gas prices, which are inherently volatile and subject to complex market forces. Realized prices could differ significantly from our estimates, thereby affecting the company’s revenues, earnings and cash flows.

Additionally, Royal Dutch Shell is 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, Royal Dutch Shell projects investment of some $34 billion in 2013, 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 in line with its peers and industry levels in the coming months and advice investors to wait for a better entry point before accumulating shares, one can look at Range Resources Corp. (RRC - Free Report) , Clayton Williams Energy Inc. and Matador Resources Co. (MTDR - Free Report) as good buying opportunities. These domestic upstream energy operators – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with potential to rise significantly from current levels.

In-Depth Zacks Research for the Tickers Above

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Range Resources Corporation (RRC) - free report >>

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Matador Resources Company (MTDR) - free report >>

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