Gas ‘Er Up!

11/05/2008 12:01 am EST


Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Allan Nichols, editor of Morningstar InternationalInvestor, says things are looking up for this mega-oil company.

In the wake of large downward reserves revisions, Royal Dutch Shell (NYSE: RDS-A) has seen its competitive position weaken. However, it remains an attractive business, thanks to strong company fundamentals.

In 2004, Shell stunned investors with a one-third downward revision to its proved oil and gas reserves. Shell's reserve life index (the ratio of proved reserves to annual production) now sits just under ten years. Further, production has declined steadily over the last several years.

Shell emerged from the incident bruised but not beaten. To restore investor confidence, management attacked weak internal controls, revamped the compensation scheme, and simplified and centralized the organizational structure.

As the firm replaces depleted reserves, it faces an uphill battle. With higher energy prices, international oil companies are battling stiffer terms from resource-holding countries, an increasing number of worthy competitors, and escalating costs.

Nonetheless, we expect Shell to continue generating solid returns. It benefits from huge economies of scale, has made progress with cost-cutting initiatives in recent years, and has not had an unprofitable year in decades.

Further, few competitors can rival Shell's technology and engineering expertise, project management skills, or capital resources. Considered a supermajor, Royal Dutch Shell has almost 12 billion barrels of proved oil and gas reserves, daily production of 3.3 million barrels of oil equivalent, the capacity to refine four million barrels a day, and about 46,000 service stations.

In July 2005, the two holding companies, Royal Dutch and Shell Transport, merged into a single entity. Triggered by Shell's reserves issues, the change should simplify the management structure, streamline decision-making, and increase accountability.

Our forecast includes several years of elevated capital expenditures and a decline in production levels due to any number of factors, including violence and funding problems in Nigeria, project delays in the oil sands of Canada, or delays at the Kashagan oil field. Further, our model incorporates weaker downstream profitability relative to recent years.

In our discounted cash-flow model, our benchmark oil and gas prices are based on Nymex futures contracts for 2008-2010. For natural gas, we are using $11 per thousand cubic feet (mcf) in 2008, $11 in 2009, and $10 in 2010. For oil, we are using $117 per barrel in 2008, $122 in 2009, and $120 in 2010.

We're raising our fair value estimate to $93 from $87 per share, based on our higher oil and natural gas price assumptions. I think the stock price decline more than offsets the decline in oil and gas prices. (The stock closed at $TK Monday-Editor.)

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