Why Royal Dutch Shell plc’s Divestment Drive Will Damage Growth

Today I am looking at why I believe Royal Dutch Shell‘s (LSE: RDSB) capital discipline programme spells trouble for potential growth.

Divestments set to keep on rolling

A variety of structural problems across the oil industry has hit Shell hard in recent times. Indeed, the oil giant reported that earnings — on a constant cost of supplies (CCS) basis — dived to $16.7bn from $27.2bn in 2013.

Not only has Shell suffered massively from a declining oil price, but rising exploration and production costs, coupled with the Oil wellproblem of massive oil theft in Nigeria, has put the bottom line under intense pressure.

These difficulties have seriously compromised Shell’s ability to chuck up vast amounts of cash, the company reporting that operating cash flow collapsed to $6bn last year from $9.9bn in 2013. As a result the company is undergoing a massive streamlining programme to rebuild its capital position and rid itself of less-bankable assets.

The company raised $300m by selling upstream assets during October-December alone, and a further $200m by divesting upstream projects across the world including Germany, Egypt and the Philippines.

And investors can expect Shell’s escalating focus on capital discipline to lead to more aggressive sales activity looking ahead — indeed, the firm confirmed last month its plans to “target growth investment more effectively, focus on areas of the business where performance improvement is most required, and drive asset sales from non-strategic positions.”

The company announced in February its intentions to sell off most of its Australian downstream operations to Vitol for $2.6bn. The deal — which includes the sale of its Geelong refinery, 870 retail sites and several chemical and fuels businesses — was one of a number of “tough portfolio choices to improve the company’s overall competitiveness,” Shell advised.

However, a backdrop of escalating asset sales is likely to weigh increasingly heavily on production in the near-term and potentially beyond — group output registered at 3.2 million barrels of oil equivalent per day, down 2% from 2012 partly due to divestments.

A risky selection even at current prices

Royal Dutch Shell has seen earnings fluctuate wildly in recent years, culminating in 2012’s eye-watering 39% decline. But City brokers expect a strong bounceback in the medium term, with earnings anticipated to surge 31% this year before marching 5% higher in 2015.

These projections leave the oil giant trading on P/E multiples of 11.3 and 10.8 for 2014 and 2015 respectively, making mincemeat of the complete oil and producers sector’s forward average of 27 and tip-toeing towards the value threshold of 10 times earnings and below.

But in my opinion Shell remains a dicey stock selection, even at recent price levels. With the cost of oil expected to dive further in the next few years as fresh supply hits the market, exploration costs on the rise and a planned acceleration of asset sales undermining long-term production forecasts, earnings growth could be set for a difficult slog in coming years.

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Royston does not own shares in any of the companies mentioned in this article.