Why Royal Dutch Shell Plc And BP plc’s Project Scalebacks Are Doomed To Fail

Royston Wild explains why Royal Dutch Shell Plc (LON: RDSB) and BP plc’s (LON: BP) latest cost-cutting measures are unlikely to improve their earnings potential.

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With the oil price collapse showing no signs of bottoming any time soon, the world’s fossil fuel giants are in a desperate struggle to ratchet up their cost-saving initiatives and cut their exposure to what is becoming an increasingly perilous market.

Just yesterday, Royal Dutch Shell (LSE: RDSB) announced that it was stopping work on a £4.3bn petrochemicals plant with Qatar Petroleum. Construction of the huge Al-Karaana complex started in 2012, but Shell has been forced to bin the operation due to “high capital costs rendering it commercially unfeasible, particularly in the current economic climate prevailing in the energy industry.”

And BP (LSE: BP) (NYSE: BP.US) followed up on this news by announcing today that it was slashing 200 jobs and cutting 100 contractor positions at its North Sea operations. The oil giant announced a fresh $1bn restructuring plan last month, and suggested that its capital expenditure target could also continue to fall — indeed, planned outlay of $24bn-$26bn for 2015 will be “reviewed further” the company said. It already said that these estimates could fall by $1bn-$2bn back in October.

Brent continues to barrel lower

Of course, such measures are pure common sense given the oil market’s worsening supply/demand imbalance. With gluts of new capacity hitting the market from the US shale sector, industry cartel OPEC steadfast in its refusal to stop pumping, and global economic activity seemingly on the slide, the sector looks set to continue swimming in the black stuff for some time to come.

The Brent benchmark has shed a staggering 60% of its value since the summer, and touched its cheapest since March 2009 at around $45.20 per barrel just this week.

The effect of this ongoing weakness is prompting the City’s brokers to hurriedly take the red pen to their market forecasts, and Bank of America-Merrill Lynch projected just today that Brent could dip as low as $31 by the end of the first quarter. It forecasts an average of just $52 per barrel for 2015.

But are cuts running too deep?

The term “cash is king” has reached an importance not seen in the oil market since the 2008/2009 financial crisis gutted out earnings across the sector. But there is a danger that, should the likelihood of widescale US shale shuttering prompt a recovery in the oil price, that Shell and BP will leave themselves with an increasingly-barren portfolio of assets from which to generate earnings growth.

BP advised back in late 2013 plans to divest a further $10bn worth of projects by the close of this year, the firm having shorn itself of $38bn by that point. And Shell has sold around $12bn of projects as part of its current $15bn drive, and follows on from billion of dollars worth of other divestments in recent times.

And it is impossible to rule out further significant asset sales and capex reductions in the coming years, particularly once upcoming fourth-quarter earnings results underline the devastating impact of a crumbling oil price.

Undoubtedly, BP and Shell are caught in a delicate balancing act between exercising fiscal responsibility in the face of current market challenges, and maintaining a sturdy earnings outlook by creating a healthy asset base. As a result I believe that earnings forecasts could be subject to severe downgrades in both the near- and long term.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Royston Wild has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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