Stock Spotlight: Shell reaps the rewards of decade-high oil prices

Europe’s biggest oil company reported record profits in the first quarter of 2022, totalling $9.1bn – far higher than the $3.2bn reported in the same period of last year. Shell is forecast to make around $35bn of profits this year, up by $15bn from the previous year.

In the stock markets, the landscape for Shell today looks very different than it did in 2020, when oil demand collapsed and drove shares to a 25-year low. In April of that year, the price of US oil dropped below $0 per barrel, meaning that oil producers were paying buyers to take it off their hands. 

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Fast forward to 2022 and Shell’s shares have leapt 35.2% in the last six months. By contrast, the FTSE 100 is down 1.2%, while the S&P 500 has declined by 20%.

“While the extremely accommodating environment in terms of the high oil price continues, Shell is likely to continue to reap rewards,” said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown. 

However, the mid-to-late June slide in the share price follows a pullback in oil and gas prices, which has fuelled uncertainty around how much the outperformance of Shell shares could hold if energy prices begin to moderate. 

Investors have largely shrugged off the UK’s windfall tax, which was introduced by the government in May to fund measures to support households during the cost-of-living crisis. Despite this, some analysts believe that a potential move to a series of such levies could be more problematic.

Valuations ‘at odds’ with economic future

Despite the meteoric rise of energy stock shares in the past year, valuations for the sector remain the cheapest in the market. This is “at odds” with its economic future, said Nick Kirrage, co-manager of the Schroder Global Recovery fund,  which holds a stake in the company. 

Thomas Moore, manager of the abrdn Equity Income trust, which has a 4.3% position in Shell, agreed, saying that the strong trading environment the company is in is not reflected in its valuation. 

According to Moore, “Shell has been ignored for years, partly on ESG grounds”. He believes that this caused the stock to be undervalued going into this crisis, with a double-digit free cash flow yield, according to consensus forecasts.

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In May, Shell announced the commencement of the second tranche of its $8.5bn of share buybacks, previously announced in February. The company also has room to increase its dividend payout, with the dividend yield currently sitting at 4%. 

Despite the slight dip in oil prices in June, some investors are predicting a ‘high for longer’ oil price environment due to significant supply concerns, which Shell is “well placed to benefit from”, said Ben Laidler, global markets strategist at eToro.

“The US has banned Russian energy imports and the UK will phase them out by the end of 2022. A partial EU crude embargo on Russian imports has also been agreed. OPEC+, the cartel of oil producing nations, has been hesitant about turning on the taps more, adding to the squeeze in supplies, partly due to production capacity issues,” said Streeter. 

Moore said that it is “hard to see any immediate moderation” in energy prices, given that the ongoing war in Ukraine is causing a severe and protracted tightening in oil and gas markets. 

“As Russian aggression continues, it is difficult to see any loosening in sanctions. Efforts to replace Russian gas with European gas and imported liquid natural gas are therefore set to continue. This should directly benefit Shell,” he said. 

Potential headwinds

Despite the bright picture for oil and gas, Laidler said that lower oil prices, whether driven by lower demand from an economic slowdown or more supply with a relaxation of Russian sanctions, would reduce the earnings outlook.

“Since 1970, the oil price has doubled year-on-year six times and on four of those occasions the US and UK have gone into recession within the next two years. Everyone is waiting nervously to see if 2022 makes it five out of six,” said Russ Mould, investment director at AJ Bell.

“A peace settlement in Ukraine, no matter how unlikely that seems, could also take some of the steam out of oil and gas prices, while there also remains the danger that governments impose additional windfall taxes.”

Although somewhat expected, the newly introduced windfall tax has caused concern among some fund managers about the prospects of investment in the UK by energy companies. Shell has said the implementation of the new windfall tax does create uncertainty, particularly over investments into renewable energy. 

Shell, however, generates the vast majority of its earnings outside of the UK, so the windfall tax is not expected to have a material impact, Moore said. The “dramatic” underlying increase in sector profits and increased tax relief on UK investments also have helped soften the blow, Laidler added. 

Energy transition risks

The dominant longer-term challenge analysts and fund managers seem to agree on is the accelerating transition away from fossil fuels. However, most argued that the company is better placed than most to manage. 

“Shell was the first major oil company to submit its energy transition strategy to a shareholder’s vote, in 2021. Progress towards its goal of becoming a ‘net zero’ company by 2050 will be the critical driver given the likely long-term decline in oil demand,” Laidler said.

Moore also sees the threat of the energy transition within a traditional energy business as one of the most notable risks for the company, but argued that the company has “a strong enough balance to weather shifts in the industry”.

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According to Streeter, the firm’s commitment to net zero will require significant investment in new technologies, or a further restructuring of the current business – neither of which will come cheap.

“Given that Shell is likely to stay an oil and gas giant for decades, there is a significant risk that investor sentiment could turn markedly and it could end up in the ethical waste bin,” she said. 

However, moving in the right direction and accelerating the shift to renewables will eat into cash flows, she noted, especially as “many of the newer technologies the industry is exploring are untested at a global scale”.

“While the oil price stays high, this is less of an issue as Shell can well afford to plunge more deeply into the energy transition, but there could be more volatile times ahead given uncertain economic and political landscape.”

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