Just over a year ago, the price of oil reached $120 and the Shell (LSE: SHEL) share price was riding a crest of a wave. In its latest trading update, however, we’ve begun to see the effect of lower oil prices translate into lower profits. Many see 2022 as an outlier year for the oil industry, but I’m not so sure.
Trading update
A drop of nearly 50% in adjusted profits from just three months ago grabbed a lot of the headlines from its Q2 update on 27 July.
When one compares this quarter’s results with that of 2019 the picture looks rosier. Adjusted earnings and free cash flow are significantly higher today, despite both production and refinery intake coming in much lower.
Cash generation remains strong, totalling $15.1bn in the quarter. This enabled it to hike its dividend per share by 15%. It now yields 4.4% which is above the FTSE 100 average.
Oil cycles
I never let one quarterly set of figures, disappointing or not, influence my investment decision. Instead, I look long-term at oil cycles.
Today’s commodities market is totally different to back in the last boom cycle that peaked in 2014. Back then, as oil topped $100, the industry acted like drunken sailors, sinking huge sums of money into exploration projects.
Awash with debt and with a glut of oil coming on-line, a lot of players got crushed as prices fell. The industry learned a lot from being burnt and today is far more conservative.
Instead of financing its operations from issuing debt, Shell and its peers are instead focusing on free cash flow generation. The company is using its cash to pay down debt, buy back shares and distribute healthy dividends. Although leading to slower oil and gas growth, this model is less risky.
There’s little incentive for the industry to invest in long-term capital expenditure (capex) because of ESG mandates and the fear that firms could be left with stranded assets in the coming decades.
This cycle still has legs
I’d sum up today’s industry sentiment as bearish, cautious and defensive. In such an environment, it’s hard for me not to be optimistic about prices.
In my view, driving a lot of the downward pressure on oil prices recently has been the huge drawdown in the US strategic petroleum reserves (SPR).
I feel we’re witnessing one of the most haphazard and irrational energy policies in history. The SPR is now sitting at its lowest levels in over 40 years. I think the worst of the sell-off is now behind us and, in the absence of a deep recession, oil prices have probably found their floor.
Investors continue to fret over the long-term future of the industry. I’m a pragmatist. In my opinion, the world is going to continue to need oil and gas for many decades to come.
There are many industries where no commercially viable alternative to oil presently exists. This includes the production of plastics, cement, steel and fertiliser.
Given the present state of the global economy, I believe investors need to worry more about short-term than long-term risks of investing in Shell. I certainly have been buying more of it shares recently on the dip.
