A big chunk of Royal Dutch Shell’s (LSE: RDSB) earnings is in US dollars and the translation effect for the London-listed firm has helped drive the share price higher since sterling’s post-Brexi referendum slump.
Sterling’s not the only driver though. A resurgent oil price this year has helped, as has operational progress — notably, improved growth prospects due to Shell’s acquisition of BG Group in February.
Beware of reversals
Looking at Shell’s share price chart, I’d wager that investor sentiment will combine with these factors to power the shares to 2,500p. The gap between today’s 2,156p or so and last year’s peak is screaming out to be filled. But what then?
Shell reports its revenue and profits in US dollars. But the company’s listing on the London stock market means that a sterling denominated market capitalisation understates the value of the firm’s profits and assets when sterling falls against the dollar. Thus the share price tends to rise to adjust for that effect as the pound plunges.
That’s delivered a handy outcome for British shareholders so far this year as Shell’s shares have shot up. However, I could argue that sterling looks like it’s on the floor. It could go lower of course, but it may rebound too, and if that happens the translation effect could reverse and act as a drag on Shell’s share price.
Trying to predict currency movements is a complex business though. Some City traders win and lose fortunes specialising in trying to do that alone. Generally speaking, currencies rise and fall against each other based on the perceived relative strength of their economies. That’s why sterling is down, traders are guessing that Britain’s economic prospects have weakened compared to, say, America’s since we voted to leave the EU.
However, it’s just a guess. The Brexiteers could be right in the end and Britain’s economic prospects could turn up in the medium-to-long term as a result of leaving the EU. If that happens, watch out for a resurgent pound that could help to cap further rises for Shell.
Shell and the oil price myth
I used to consider arguments that the price of oil doesn’t affect oil majors too much because downstream and upstream operations tend to balance each other out. Bunkum! The recent slide in the price of oil teaches a different lesson. Oil producers, including big ones such as Shell, have been bent double from the blow of lower oil prices as their cash flows dwindled and operations became uneconomic. I reckon the price of oil and what it does from here will be a big factor in where Shell’s share price goes.
Shell is a commodity producer and therefore inherently cyclical. Right now we seem to be seeing over-supply affecting the oil price, but reducing demand could also take its toll down the road. Cyclicals don’t make good buy-and-forget investments. Their profits and share prices tend to be volatile, so Shell’s high-looking dividend yield may not indicate as much value as we might think. After all, forward earnings only cover the payout around once and that’s after City analysts have pencilled-in a dramatic recovery in profits over the next couple of years.