Investors in Shell have had a good year with the energy company’s share price up over 40% since early January. Its most recent climb came this week with almost 6% added to its valuation after it announced a doubling of quarterly profits and a new $4 billion share buyback thanks to high oil and gas prices.
Oil and gas prices could remain high for some time, which would maintain outsized profits for Shell and its big oil and gas peers like London-listed rival BP. However, there is also the risk of a new windfall tax being imposed by the UK government to help fund the energy bill price caps for households and businesses until at least spring 2023.
Despite the decision of the UK government to raise the rate of tax on North Sea oil profits from 40% to 65% in March, Shell hasn’t actually paid any profits on its North Sea business since 2017. The company’s investments in the business have seen it make an accounting loss and receive tax rebates since then. Under the current rules, Shell doesn’t expect its North Sea business to pay any tax before late next year.
Sinead Gorman, Shell’s chief financial officer highlighted investments made in the existing Pierce field and the recently approved Jackdaw project that will increase its North Sea gas output in future years, concluding
“we simply are investing more heavily than we have, and therefore we don’t have profits which we can be taxed against”.
But Shell has earned over $30 billion in profits overall this year across its business including $9.5 billion banked for the third quarter. Sunak’s Conservative government wouldn’t be expected to be ideologically inclined towards heavy windfall taxes for either the country’s big oil firms, or banks. The latter is another sector seeing profits leap thanks to higher interest rates and has been mentioned as a target for a windfall tax to help plug the UK’s huge balance of payments deficit.
But a new windfall tax has to be considered a risk to Shell’s profits next year even if, at this stage, it looks unlikely to make a major impact. CEO van Beurden even seemed to acknowledge the likely hood of a new windfall tax, saying that it may be “for the right moral reasons”, to “help the most vulnerable” with their bills. He concluded “we have to accept it and embrace it.”
Investors that hold Shell shares or are still considering adding them to their portfolio despite the large gains the company’s valuation has already made this will be more focused on the potential impact of the $4 billion share buyback announced. And the potential bumper dividends continuing high prices would be expected to deliver.
Is Shell still a strong buy despite 40% gains in 2022?
The big question is if Shell’s valuation has already or might be near to peaking in this cycle. If energy prices come down again next spring as many hope, and the global energy supply picture looks like it will hold the price of a barrel of oil below $100 for the foreseeable future, that would be expected to hit the Shell share price.
Many in the industry see $90 a barrel as the ideal level – high enough to encourage investment, especially in new renewables capacity but not so high as to put too much pressure on the global economy. That would be enough to maintain Shell’s profitability at an attractive level.
Dividends are another big pull for Shell investors. Could the prospect of rising dividends make a case for investment at the company’s current valuation even if most of the big share price gains have already been banked? Shell has already promised to raise its quarterly dividend payment by 15% to 28.75 cents-a-share after last week announcing a $9.5 billion profit for the last quarter.
Even if oil and gas prices drop back towards $90, Shell would not be expected to reduce its dividend again if it doesn’t have to. Despite prices dropping back from levels above $100 a barrel of Brent crude earlier in the year they still average more than $100 over the third quarter. A year ago the average price was $74. Gas prices are also still more than double their level over the third quarter of 2021.
So how likely is it that oil and gas prices will be considerably lower next year compared to this? Some analysts think there is a significant chance they will be high again next winter because supply to Europe has been eased in recent months as a result of China’s strict Covid lockdowns in recent months reducing demand.
If that’s not the case again next year, and it’s difficult to see China not wanting to get its economy revving again, supply could be tight once more. Especially if the war in Ukraine still represents a major geopolitical crisis. At this stage, that looks more likely than not.
Shell reduced its dividends for the first time since World War II when the Covid-19 pandemic hit in 2020 from 48 cents-a-share to 16. Even with the recent rises, dividends still sit some way off that pre-pandemic level, which suggests they could continue to be raised next year if profitability remains at heightened levels. They may not return to previous levels while the justification of huge investment in Shell’s net zero transformation by 2050 remains but they could still rise significantly. This week it was announced $4 billion will be invested in renewables and energy solutions this year.
Chief executive Ben van Beurden delivered his final set of quarterly results last week and after being in the top job since 2014 he’ll be succeeded at the end of the year by Wael Sawan, currently Shell’s head of integrated gas and renewables.
That transition will be one thing for Shell investors to keep an eye on but Sawan is an experienced pair of hands and it is expected the hand-over will prove smooth.
With total distributions to shareholders already in excess of 30% of cash flow from operations (CFFO), Shell investors are being well rewarded throughout this purple patch for the sector. With much of the rest of the stock market expected to struggle through a recession in 2023, Shell’s dividends and the potential of more share price upside if energy prices remain high could be very tempting. That would create a virtuous circle be expected to further benefit the company’s valuation.
But would a global recession next year hurt demand enough to pull oil and gas prices back down below $90? It’s not impossible but seems unlikely. In an effort to increase supplies this winter and keep prices under control, the US government has been selling off its strategic petroleum reserves at a record rate. The can’t continue as maintaining the current rate would see those reserves hit zero within 18 months.
That means inventories will probably remain extremely tight and there is a lack of new supply coming online over the next few years, a hangover from the rock bottom prices over the pandemic. Capital expenditure levels remain low in an historical context and solving that will require a complicated balance between net zero targets and international consensus on energy security in the meanwhile.
Looking at the bigger picture, there seems little likelihood of oil falling consistently below $90 a barrel over the next 2-3 years. And that would almost certainly see the Shell share price continue to outperform. Especially against the broader economic backdrop that will hurt most other sectors.
The Shell dividend may not be spectacular considering its recent profits but it also looks secure with this year’s payout covered five times over by earnings compared to a long term average of two times earnings. The company has also been taking advantage of its record revenues and profits to cut debt, as well as investing in share buybacks and increasing the dividend again. By late June this year, net borrowings had been brought below $50 billion from $79 billion in 2019.
Dividend growth is expected to slow next year, especially if profits decline. It may not be the best income stock but it does look like a safe one, a quality investors are unlikely to undervalue against the backdrop of the economic conditions expected next year.
