Royal Dutch Shell - Moving upstream

Ramping up production for the large Western integrated oil majors is easier said than done. BP Plc has bet heavily on Russia and deepwater drilling while BG Group has turned to Brazil and partnered up with the national oil company, Petrobas, to exploit huge deepwater oil and gas finds. Royal Dutch Shell B (LON:RDSB) meanwhile has also turned to Russia as well as investing heavily in liquid natural gas production (LNG), oil sands production and more recently in shale gas.This serves as an escape from declining UK North Sea and North American production.

However, the risks of investing in these areas have been highlighted by difficult negotiations in Russia and BP’s difficulties with the deepwater Gulf of Mexico spill. Nevertheless, it is the upstream (areas which produce oil and gas) activities which are the key profits generators as energy prices increase. Therefore Shell’s focus on increasing production and reducing exposure to downstream areas (such as refining, marketing and distribution) is to be welcomed.

After all downstream activities don’t necessarily benefit from energy price increases. By way of example, when the oil majors are criticised for excessive profits due to high petrol prices at the pumps, their response is that they make little money from petrol stations. Turning to the third quarter results for Shell and output of oil and gas rose by 5% in the third quarter helped by a 22% rise in liquid natural gas sales (LNG). Energy prices were also up on a year ago with oil averaging US$76 a barrel in Q3, 12% up on Q3 2009, and natural gas futures increasing by 23%.

Both of these factors, in combination with cost cutting, helped third quarter CCS (current cost of supplies basis) earnings, excluding one-off items, come in at US$4.9 billion versus US$2.6 billion a year ago. It was the upstream operations that drove this profits growth and more should be in the pipeline.

Natural gas prices have been weak in the United States as production of previously un-exploitable shale gas resources has been ramped up. Thus energy firms have been victims of their own success as new technologies have increased natural gas production and softening prices.

It is worth noting that Shell is developing the US$19 billion Pearl gas-to-liquids plant in the Qatar. The Middle Eastern State has huge natural gas resources but a small population which ensures that it will be a major exporter. Shell’s plant is due to be fully operational in Q1 2012.

This is important for Shell as such projects are cheaper than producing natural gas from conventional sources and then liquefying it for transportation elsewhere. Other key projects include oil sands ventures in Canada and deepwater projects in the Gulf of Mexico and Brazil. By contrast the group has recently agreed to sell its downstream businesses in Sweden and Finland for US$640m. Asset sales are being accelerated with as much as US$8bn expected this year and in 2011. In our view this is the right direction as the returns for Shell’s expertise are much higher in upstream activities.

This article was produced by Senior Research Analyst, Andrew Latto.