Royal Dutch Shell (LSE: RDSB) is one of the most talked about companies today, with the oil and gas producer announcing that it will cease drilling in Alaska. The reason for this is very straightforward: the company has drilled to 6800 feet and, despite the basin demonstrating many of the key attributes of a major petroleum basin, the indications of oil and gas present are insufficient to warrant further exploration. As such, the well will be sealed and abandoned.
Due to this, Shell will inevitably take a financial hit. The carrying value of Shell’s Alaska position is $3bn, with a further $1.1bn of future contractual commitments. And, while Shell believes that there remains exploration potential elsewhere in the basin, it will not return for the foreseeable future.
Although the news is disappointing for the company’s investors, Shell’s share price is relatively unmoved by the update. Clearly, a lack of oil and gas is the main reason for the abandonment, but across the industry a number of companies are cutting back on capital expenditure and exploration as a lower oil price makes such activity less appealing.
In the short run, the price of oil could fall further. It has shown little sign of recovering above $50 per barrel and, realistically, it could take a number of years for it to begin to move upwards, with a more balanced supply/demand interaction likely to be the catalyst.
In the meantime, Shell appears to be an excellent investment. It is financially very sound and, having taken over BG, is in the midst of a period of major transformation which is likely to see the company become much more efficient, leaner and potentially more profitable. This in itself has the potential to positively catalyse investor sentiment in the company, which could help to push its shares northwards after their fall of 36% in the last year.
Of course, for long-term investors, the short-term challenges posed by a lower oil price present an opportunity to buy at a lower price and lock in higher potential gains. For example, Shell trades on a price to earnings (P/E) ratio of just 11.8 and could, therefore, be rated upwards in the coming years. Meanwhile, a yield of 7.9% indicates that Shell remains a truly stunning income stock, with dividends due to be covered 1.2 times by profit next year.
Looking ahead, there is a good chance that other exploration activities will be curtailed by Shell due to the lower oil price environment. This would be a sensible move since a number of projects may prove to be less economically viable than they once were, with high costs in Alaska and a challenging regulatory environment also being key reasons for the decision to end exploration there. And, as with Shell’s Alaska operations, projects can be restarted should the company decide to increase exploration spending in future due to an improved outlook.
So, while today’s news is disappointing, it is perhaps not a great surprise. The oil industry may be enduring its toughest period for many years but, for long term investors, companies such as Shell present a superb opportunity to buy low, receive a high yield and sell at a potentially much greater price in the long run.
