Shell's higher risk for lower returns

Royal Dutch Shell’s major profit downgrade last Friday may have surprised markets but there were a lot of familiar strains to the explanation for the earnings slump, followed on Monday by the sale of its $1.3 billion Wheatstone-Iago interest.

Despite the continuing high price of oil – Brent crude remains comfortably above $US100 a barrel – Shell said it expected fourth-quarter earnings to fall from $US7.3 billion to $US2.2 billion and full-year earnings for 2013 to be down from $US27.2 billion to $US16.8 billion.

While some have linked the downgrade to the "new broom effect" – Shell’s chief executive Ben van Beurden only took over the role a few weeks ago – its explanation of the drivers of the downturn reflects near-perfectly the conditions the energy majors have been experiencing.

Soaring exploration and development costs, weaker refining margins because of surplus capacity in Asia and Europe, lower marketing and trading profits and a weak Australian dollar were among the factors cited.

Add losses from its North American upstream operations – Shell, like some of its peers, made a late and costly entry into the US shale gas sector, which it is now unwinding – and the key strands of the explanation for its falling profits echo what we’ve seen across the Australian resources sector generally in the past couple of years.

The common theme right across the resources sector has been spiralling costs, whether operating costs or, in particular, the cost of building new projects.

In the case of the oil majors, and perhaps even more so for Shell, the cost of exploring for and developing new energy resources to offset the depletion of existing reserves has escalated as they have been pushed into more difficult and risky jurisdictions and more complex and higher-cost resources.

Shell, which has traditionally been proud of its engineering capabilities and innovation, and which has pursued what it calls "elephant projects" that can make an impact on a group its size, is perhaps more susceptible than most to an across-the-board blow-out in costs. It has written down billions of its shale gas and oil sands projects.

A broader perspective, however, would be that the massive cash flows of the energy majors – Shell had operating cashflows of about $US40.4 billion in 2013 (down from $US46.1 billion in 2012) and the continuing high oil and LNG prices – meant that they were tardier than the big miners to really start focusing on capital efficiency and operating costs.

Shell had previously flagged a major spring cleaning program under which it plans to sell at least $US15 billion of assets over the next couple of years, with its residual 23 per cent stake in Woodside Petroleum expected to be offloaded imminently.

Its Geelong refinery and potentially its retail business are also up for grabs and on Monday, perhaps in keeping with a more cost and capital-conscious approach, the Shell-PetroChina Arrow Energy joint venture cut more than 200 jobs. The prospect of the joint venture proceeding with its proposed coal seam gas-fed LNG plant at Gladstone – where three other $20 billion-plus plants are well underway – is fading fast.

Shell, along with a number of the other energy majors, has a big pipeline of offshore gas projects in Australia, most of which are too far advanced to walk away from. Most of the offshore projects have experienced big cost blow-outs and delays.

The problem for the big oil groups is that they have to keep exploring and developing despite the inevitably higher risks and costs of having to produce oil or gas from riskier or more remote or deeper regions in order to maintain their reserves and production.

A factor in Shell’s downgrade, which provides some insight into a potential future for the energy groups if they don’t reduce the capital intensity of developments and rein in their costs, was that its higher costs coincided with lower output. It lost some production due to maintenance but it is also experiencing continuing problems within its Nigerian operations, where oil theft and even sabotage has been rife.

Whatever the reasons, however, the Shell numbers show how the combination of higher costs and lower production can squeeze profitability.

If oil prices happen to fall, as some are predicting, the impact would, of course, be leveraged. There’s good reason for Shell and its peers to act quickly to get their houses in better order.