Should I Buy Royal Dutch Shell? 3 Pros, 3 Cons

by Tom Taulli | August 15, 2013 11:46 am

There’s not much to like about Royal Dutch Shell (RDS.B[1]) lately.

According to the company’s latest earnings report, year-over-year profits dropped by nearly 20%, down to $4.6 billion. Meanwhile, revenues fell by 3.8% to $112.67 billion. Some of the factors behind the drops included problems in Nigeria, volatile currencies (especially in Australia) and a $2.1 billion charge for shale assets.

So of course, the stock price has remained an issue. For the year so far, the return is a miserable 7%. But thanks to that drop, shares are trading at a good value. So should you buy RDS in hopes that the company will get back on track? Here are the pros and cons:

Pros

Big Oil: RDS is part of this rarefied group. Shell operates in more than 90 countries and has a fully integrated platform, with both upstream businesses (exploration and development) and downstream categories (like refining, shipping and gas chains). With its massive scale, RDS has the advantage of making long-term investments. One area the company has been aggressive in is renewable energy. For example, there is a notable joint venture in Brazil, which turns sugar cane into ethanol, which produces much lower CO2 emissions than standard gasoline. Shell forecasts that renewable energy will account for 30% of the world’s energy by 2050.

New Leadership: The current CEO, Peter Voser, is leaving the company in January. Ben van Beurden, who has been with RDS for 30 years, will take his place. In light of the stock performance, he’ll be under lots of pressure to get things back on track, but Beurden could be the right fit. He proved his leadership back in 2006 by staging a turnaround of the chemicals business. He also spent a decade in the natural gas segment and had stints in places like Nigeria and Malaysia, which could translate into valuable experience in his new position.

Valuation: Shares of RDS currently trade at a price-to-earnings ratio of only 9. That’s significantly cheaper than P/E ratios of 11 for competitors like Exxon Mobil (XOM[2]) and ConocoPhillips (COP[3]). But more importantly, RDS has a juicy dividend that yields 5.3%.

Cons

Dividend: Investors should be legitimately worried about RDS ultimately cutting that juicy dividend. Shell’s $16.8 billion in operating cash flows in the first half of this year was not enough to cover the ongoing capital expenditures and dividend. As a result, the company might have to cut back on its investments, which could result in muted growth for the long-haul.

More Write-Offs: RDS was stuck with a $2.1 billion charge as a result of the complexities of finding oil from shale. Essentially, the company overestimated the reserves. And as RDS explores more of its fields, that problem could pop up again. Keep in mind that RDS has invested $24 billion in shale properties over the past few years, meaning there’s a lot of money to lose with those kinds of mistakes.

Reserves: These are the lifeblood of an oil major, and it’s only getting tougher to find new sources. While there is lots of potential in places like Africa, South America and Russia, politics can be a huge barrier. Often oil companies must pay hefty fees and tariffs, and in some cases a government will just forbid any foreign company to get a piece of the action. Shell is feeling the pressure, and says it probably will not hit its goal of increasing oil production from 3 million barrels per day up to 3.7 million by 2014 and 4 million by 2018. In fact, the company won’t even publish forecasts anymore!

Verdict

Again, RDS certainly has lots of issues. But the play is really about the long-term potential of oil prices. If you think they will rise over time, then Shell will start to ramp its cash flows again — and the dividend is likely to be rock-solid.

And, for the most part, there are bullish signs for oil prices. The U.S. economy is growing again. It even looks like Europe is starting to improve. Besides, it will still take a long time for alternative energy to take away meaningful share from fossil fuels.

Actually, Shell believes that these trends will continue. As a result, the company thinks that it will generate a whopping $200 in cash from 2012 to 2015, based on expected prices of $100 per barrel.

So should you buy RDS? Yes. If you’re an investor looking for a long-term option on oil, along with a nice dividend payout, the pros outweigh the cons.

Tom Taulli runs the InvestorPlace blog IPO Playbook[4]. He is also the author of High-Profit IPO Strategies[5]All About Commodities[6] and All About Short Selling[7]. Follow him on Twitter at @ttaulli[8]. As of this writing, he did not hold a position in any of the aforementioned securities.

Endnotes:
  1. RDS.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=RDS-B
  2. XOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=XOM
  3. COP: http://studio-5.financialcontent.com/investplace/quote?Symbol=COP
  4. IPO Playbook: http://investorplace.com/ipo-playbook/
  5. High-Profit IPO Strategies: http://goo.gl/TXQsz
  6. All About Commodities: http://goo.gl/FfP8R
  7. All About Short Selling: http://goo.gl/t5Jzb
  8. @ttaulli: https://twitter.com/ttaulli

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