Is Shell really still a Super Stock?

Correction: This article previously missed a disclosure statement. Roland Head owns shares in Shell.

Anyone who bought big oil stocks in the depths of the 2020 crash has done very well. Shell (LON:SHEL) shares have more than doubled since October 2020. The dividend is also now 50% above the reduced payout announced in 2020.

Shell’s share price recently topped its pre-pandemic level, before slumping as the market started to price in weaker demand for oil.

However, Stockopedia’s algorithms are taking a more bullish view. They’ve digested the group’s half-year results and still rate Shell as a Super Stock, with a StockRank of 99.

Shell’s dividend looks rock solid to me and I do not expect another cut. But with profits expected to peak this year, I’m unsure of the case for growth or a further re-rating of the shares.

To find out more, I’ve decided to dig into the story (and the numbers) a little further this week.

Known knowns, unknown unknowns

Early on in my investing career, a much more experienced investor told me to remember that the oil market always overshoots.

We saw this in the early months of the pandemic, when the price of some oil contracts briefly went negative. There was a new groundswell of pressure on fossil fuel producers to clean up their acts. Very little attention was given to the inevitable rebound in energy demand when the pandemic eased.

I wonder if we’re now seeing energy markets overshoot to the upside. Brent Crude recently came close to $140 per barrel, before settling back around the $100 mark.

Source: IG Group

For Shell and its rivals, high oil prices have been a boon. But oil prices are still well above pre-pandemic levels. This seems to assume that demand will be higher than in 2019, or that supply will be more restricted. I’m not sure how strong either argument is.

For example, this recent FT article (paywall) suggests to me that the UK, EU and US may be inclined to continue allowing Russian oil shipments, as long as they are going elsewhere.

Shell’s own Brent crude price assumptions are for $80 for 2023, and $70 for 2024. These numbers would leave oil trading broadly in line with pre-pandemic levels.

In addition to high oil and gas prices, Shell’s refineries have also driven profits higher this year. The company’s average refining margin per barrel quadrupled from $5.70 in Q3 2021, to $28 per barrel in Q2 2022.

This increase was driven by fears that sanctions could trigger fuel shortages. But I think that any sign of slowing demand would relieve this pressure.

In short, I think this is a difficult situation for investors. Shell is trading well and looks very cheap. But profits seem likely to drift lower, perhaps for several years. What’s a fair valuation? Let’s take a look at the numbers.

Valuation: one metric that isn’t cheap

Shell has a ValueRank of 88 and looks cheap on many of my favourite valuation metrics.

• Earnings yield (EBIT/EV): 20%
• TTM P/E: 6.4
• TTM P/FCF: 5.4
• Price/book: 1.0

If the current levels of profit and free cash flow are at all sustainable, then the shares appear to be very cheap.

However, there’s one valuation metric that suggests to me that Shell’s share price is already well up with events. The dividend yield.

Shell’s trailing dividend yield is only 3.7%. Although the payout has risen quite quickly since being cut in 2020, I think it’s worth remembering that Shell’s medium-term guidance for 4% annual dividend growth remains in place.

Recent dividend growth has exceeded this rate, but only due to the exceptional circumstances. I’m not convinced these will continue. Broker forecasts support this view. Consensus estimates show dividend growth slowing to more normal levels from next year:

Expected rate of return: One valuation technique I like to use is to estimate the expected rate of return by adding a stock’s dividend yield and its forecast dividend growth rate.

This approach is based on the assumption that the share price will change to keep the dividend yield constant.

Here, we can see that Shell’s expected rate of return is likely to be around 9% over the next year, based on a 4% yield and dividend growth of 5%.

9% is slightly above the long-term average annual total return from the UK market of 7%-8%. On this basis, I’d say that Shell shares might be slightly cheap.

For a mature business that’s expected to report declining earnings and has a mediocre record of through-cycle profitability, I don’t find this level of value very tempting.

This leads me to the conclusion that the real opportunity here is that market conditions will remain stronger for longer than expected.

I think that Shell’s momentum metrics do provide some support for this view.

A third momentum factor?

Shell’s MomentumRank of 99 suggests a very strong technical picture. The numbers certainly stack up well.

The stock’s price momentum metrics are mostly green, although the recent sell-off is reflected in negative 1m relative strength and a fall in trading volumes versus the three-month average:

The consensus trend chart also show repeated earnings upgrades over the last 12 months:

A third momentum factor: Shell’s current profitability and strong cash generation is supporting massive share buybacks and ongoing debt reduction. These activities are taking place on a fairly epic scale.

Net debt has fallen by $22bn since the end of 2020, and Shell has committed to share buybacks of $15.5bn in 2022 alone. That’s around 8% of the group’s current market cap.

While share buybacks don’t directly put cash in shareholders’ hands, they do help to support earnings per share growth and cut the cost of future dividends. Deleveraging has a similar effect, ultimately.

If I’m wrong, and commodity market conditions stay stronger for longer, Shell will also be able to cut debt and reduce its equity base to a greater extent than expected. That could provide a strong tailwind for future shareholder returns.

Conclusions

It’s not hard to see why Shell might be classed as a Super Stock. The shares look cheap and the business has strong fundamentals, improving profitability, and stunning momentum.

However, while I am a big fan of systematic investing, I can’t completely ignore what the company’s own management appears to be telling us.

Shell’s dividend is expected to be covered five times by earnings this year. But rather than consider a special dividend for shareholders still smarting from the 2020 cut, Ben Van Beurden and his board are focusing resolutely on buybacks and debt reduction.

This approach tells me that Shell’s board believes that the future will be smaller. Smaller profits, and perhaps lower returns on investment as the focus tilts to renewables.

Higher levels of capital expenditure may also be needed at some point, to fund future returns and more ambitious acquisitions.

Ultimately, I can see two plausible but quite different pictures for Shell shares. Personally I’m cautious, but this is a situation where we all need to DYOR and decide for ourselves.

Disclosure: Shell is a constituent of the SIF Folio Roland Head owns shares.