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Royal Dutch Shell - writedowns to weigh on second quarter

Nicholas Hyett, Equity Analyst | 30 June 2020 | A A A
Royal Dutch Shell - writedowns to weigh on second quarter

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Shell has warned that significant adjustments to longer term oil price and interest rate expectations will result in impairments of $15bn-$22bn to the value of its assets in the second quarter.

However, production and utilisation is now set to be at the higher end of April's expectations, or even above, across all divisions

The shares fell 1.3% in early trading.

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Our View

The collapse in oil prices has sent a shockwave through the oil industry. It started with a massive surge in Saudi Arabian supply, when the production agreement between Russia and oil cartel OPEC broke down. But the challenges have now shifted into demand too as the coronavirus outbreak sees economies grind to a halt and fuel use fall.

Oil majors like Shell are better placed than smaller rivals, but this is still cripplingly bad news for profits. Underscoring the severity of the situation, management felt the need to cut the dividend for the first time since WWII. The language of a "reset" indicates that this may be a permanent reduction and not a temporary measure.

There's nothing Shell can do to influence the price of oil though. Just as the crash came out of the blue, predicting the path of a recovery is likely to be equally thankless. While Shell reckons $60 a barrel as a long term average, the price has been below that for much of the last 5 years.

It's no surprise then that Shell is taking a hatchet to the cost base. Aside from cutting the dividend the group plans to take around $3-4bn off operating costs over 12 months and 20% off planned capital investment. Despite those efforts impairments to asset values are pushing up gearing in the short term and could mean that keeping the balance sheet in good health requires further asset sales.

In the long run the cash freed up may, if oil prices recover, help the group transition away from fossil fuels. We think this is probably a long way off though, and relies upon a profitable core oil & gas business for funding.

Shell certainly faces a tough few months, if not longer. The group's resources are immense but not infinite, and it needs higher oil prices before it can get back onto the front foot. While we think demand for oil will strengthen again once the world economy recovers from COVID-19, how long that takes and what scars Shell is left with remain to be seen.

Shell key facts

  • Forward 12 months P/E ratio - 20.6
  • 10 year average forward 12 months P/E ratio - 11.6
  • Prospective yield - 5.5%

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Second Quarter Update

Shell's new oil price assumptions, based on the price of Brent crude, are $35 a barrel in 2020, $40 in 2121, $50 in 2022 and $60 in 2023 and into the long-term. The group has also downgraded long-term refining margin expectations by 30%.

These new assumptions, as well as changes to long term interest rate assumptions, are expected to results in impairments of $8-$9bn in Integrated Gas, $4-$6 in Upstream and $3-$7bn in Oil Products. That will result in a pre-tax impact of $20-$27bn.

Since pricing contracts in LNG are price-lagged by 3-6 months most of the impact of lower oil prices on profitability in Integrated Gas will increase from June onwards. However, Upstream is expected to be loss making this quarter while increased trading provides some support to Oil Products.

Impairments are expected to increase gearing by 3%, with further impacts from lower interest rates on the group's pension revaluations and other quarterly movements. Shell continues to estimate that a $10 movement in the oil price has a corresponding $6bn impact on cash flow.

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