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Oil Spikes: How About Royal Dutch Shell plc?

Forget about the recent oil spike and macroeconomic trends. At Shell (LSE: RDSB) (NYSE: RDS-B.US), capital allocation will make the difference in years to come.

What’s Going On?

Shell shares are up almost 14% this year, which is by all means a respectable performance. The shares are changing hands above the three-year high they recorded in January 2012. Based on trading multiples, they are fully priced.

If the oil behemoth continues to explore shareholder-friendly options, however, its equity valuation will certainly continue to rise. For that to happen, it needs higher returns than those it managed to deliver in the last 18 months.

royal dutch shellBuybacks And Dividends

“The expectation is that buy-backs will offset prior dilution created by scrip dividends by the end of 2015, with approximately 135 million ordinary shares currently outstanding, as well as shares from any uptake on the programme related to the dividend in the first quarter of 2014,” Shell said on 22 May.

Essentially, all future dividends will be paid in cash. Moreover, buybacks will continue. I won’t bore you with the details of the new programme, according to which Shell will buy back A shares rather than the more expensive B shares, but that’s good news for investors.

Capital Discipline

Capital discipline is of paramount importance. Shell has decided to cut capital expenditures in 2014 as it focuses on the restructuring of its operations in North America, among other things. This is one troubled part of the business that will be difficult to turn around but could offer material upside.

Moreover, improved working capital management means that Shell’s operating cash flow in 2014 could come in higher than $46bn – the level it recorded in 2012. It hit $42.8bn in the last twelve months ended 31 March 2014.

How long it will take to grow cash flow will be key for Shell stock. The purchase of Repsol assets, which was completed in January, will add at least 2% to 3% annually to Shell’s operating cash flow. As several analysts have recently noted, a subdued performance in the second half of 2013 may help Shell beat market expectations in the next few quarters. Targeted asset disposals are also in the pipeline.

Mr van Beurden

Shell CEO, Ben van Beurden, keeps banging on the group’s priorities: higher growth and better returns. Only six months into the job, he must deliver — and quickly.

Better returns are everything investors want to see from Shell. Return on assets and return on equity stood at 4% and 7%, respectively, in the last 12 months ended 31 March 2014. They are both at their lowest levels in about 20 years.

Oil On Its Way Up

For opportunistic buyers, Shell is a buy now. A short-term fillip comes from tensions in Iraq, which have led to higher oil prices in the last 24 hours. When looking for value, however, short-term trends are not important.

Shell is still a restructuring play. Whether its stock will surge or not depends on how swiftly management will implement their vision. 

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Alessandro doesn't own shares in Shell.