Key points
- High oil and gas prices mean Shell generated $40bn of spare cash last year
- Buffett is known for liking business that’s generate plenty of cash
Shell (LSE: SHEL) shares are trading at the highest level seen since the start of the pandemic. Soaring oil and gas prices mean the company is currently producing huge amounts of surplus cash, even though investment in low-carbon energy is increasing.
Is Shell the kind of cash-generative, mature business Warren Buffett might buy? I’ve been taking a look.
Bumper profits
Shell’s 2021 results were expected to be good, but they turned out to be better than forecast. The FTSE 100 group generated adjusted earnings of $19.3bn last year, up from just $4.9bn in 2020.
Oil companies’ profits can be hard to understand, due to some complex accounting. I prefer to focus on a much simpler metric — free cash flow. This represents the surplus cash generated by a business each year. This money can be used for dividends, for example.
Shell generated free cash flow of $40.3bn in 2021, more than double the $20.8bn it reported in 2020. This tidal wave of cash helped to support a $23bn reduction in net debt. Some of this cash will also be used to fund $8.5bn of share buybacks and Shell’s quarterly dividend, which will rise by 4% this quarter.
I can see lots of elements that Buffett might like here, but is Shell really his kind of stock?
Would Buffett buy Shell shares?
Buffett once said that “our acquisition preferences run toward businesses that generate cash, not those that consume it”. Shell certainly ticks that box at the moment.
And although he is known to have a liking for defensive businesses like Coca-Cola, he’s not shy about owning energy stocks. Buffett’s firm Berkshire Hathaway reported a $3.9bn holding in US oil giant Chevron at the end of September.
So would he buy Shell? Ultimately, I don’t think so. But I suspect the main reason for this might be that it’s a European business.
Buffett believes strongly in the importance of staying within his circle of competence when he invests. For him, one element of this is his deep knowledge of the US market and American business. As a result, he rarely invests outside the US. Given that there are suitable alternatives to Shell on the US market — such as Chevron — I think he’s unlikely to buy Shell shares.
Here’s what I’d do
My experience suggests that the best time to buy commodity stocks is when prices are down. That’s not true at the moment. Oil and gas are both trading at levels which haven’t been seen since 2014.
The problem with this is that history suggests prices won’t stay high forever. When they fall, Shell’s profits are likely to drop, and investor sentiment will weaken.
Admittedly, Shell shares look quite cheap at the moment, on around eight times 2022 forecast earnings. However, these could be peak earnings.
I think the dividend yield is a better measure of valuation. Shell’s share price surge has pushed the stock’s yield down to around 3.4%. I’d want a yield of 4-5% to invest in this mature — and possibly declining — business. That means a share price of around 1,600p.
I might buy Shell shares, but not at the current price.
