What should investors in Royal Dutch Shell (LSE: RDSB) be worried about?
As one of the world's largest independent oil and gas companies, Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US) is a business with very definite attractions. A £132bn FTSE 100 (UKX) constituent, last year the company earned a pre-tax profit of $56bn on revenues of $470bn.
So it's no wonder that this defensively-positioned business is popular with many investors. Today, with its shares changing hands at 2,084p, the company is rated on a cheap-looking prospective price-to-earnings ratio (P/E) of 8, and offers income investors a very tempting forecast dividend yield of 5.2%.
But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in Shell adversely impact investors' wealth?
In this series, I set out to answer just these questions. My starting point: Shell's latest annual report, where the company's directors are obliged to address the issue of risk.
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of Shell's size and calibre, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are those risks that the company faces?
Read the small print, and Shell identifies no fewer than 19 risks as having a significant prospective impact on the company's financial performance. They range from its ability replace oil and gas reserves to competitor activity, and from project management to political risks in countries such as Nigeria.
So let's take a look at three of the biggest.
Fluctuating commodity prices
Fairly obviously, Shell is in the oil and gas business -- and you only have to look at the present low price for American natural gas to realise that hydrocarbon prices aren't a one-way bet. And as new technologies such as fracking begin to make a discernable difference on supply levels, investors can expect to see more such reminders. As Shell puts it:
“Our operating results and financial condition are exposed to fluctuating prices of crude oil, natural gas, oil products and chemicals... price fluctuations have a material effect on our earnings and our financial condition.”
What can Shell do about this? Not a lot, beyond strive to lower its cost of production, in order to keep a decent margin between revenues and production costs. An extensive downstream operation helps, as do long-term contracts, but ultimately there's no escaping the link between profitability and oil and gas prices.
Estimation of proven reserves
It's less than ten years since a major scandal saw Shell fined £17 million by the Financial Services Authority, and the ousting of then-chairman Sir Philip Watts, after the company was caught mis-stating its proven reserves. Shareholders subsequently received hundreds of millions of pounds of compensation. Just as significantly, of course, proven reserves could be correctly stated -- but downwards, directly hitting shareholders' assets. Here's what Shell says:
“The estimation of proved reserves involves subjective judgements based on available information and the application of complex rules, so subsequent downward adjustments are possible. If actual production from such reserves is lower than current estimates indicate, our profitability and financial condition could be negatively impacted.”
Reserves estimation is every bit as much an art as a science. What's more, it's also impacted by the price of oil: reserves counted as proven at one price may be de-listed if a lower price of oil made their extraction uneconomic. Regulatory rules can change, too, banning oil extraction from proven reserves if -- say -- those reserves were located in an environmentally sensitive area.
Shell mainly self‑insures its risk exposures.
Shell is big. Very big. So big, in fact, that it self-insures its risks, rather than pay premiums to third-parties. So far, the practice has served it well. But, as oil and gas giant BP discovered to its cost in the wake of the Gulf of Mexico Deepwater Horizon disaster, the result could be an obligation to cough up billions of dollars in fines, clean-up costs, and compensation. As Shell puts it:
“Shell mainly self‑insures its risk exposures... [through] Shell insurance subsidiaries which provide insurance coverage to Shell entities. While from time to time the insurance subsidiaries may seek reinsurance for some of their risk exposures, such reinsurance would not provide any material coverage in the event of an incident such as BP Deepwater Horizon.”
In short, were a BP-type disaster to occur -- and just last month, BP agreed to pay a fine of $4.5bn, the largest in American history, in relation to the Gulf of Mexico disaster -- then Shell and its shareholders would be on their own.
How painful might that be? Just ask shareholders in BP, who suffered a halving of the share price, and the suspension of the dividend.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend re‑invested basis over the 15 years to 31 December 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Mr Woodford's largest and most successful current picks.
And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.
> Malcolm owns shares in BP, but not in any other companies mentioned here.