Shell's Oil Isn't Stranded Now But Tomorrow Matters More

(Bloomberg Gadfly) -- The 92220 Evening Star was the last steam locomotive built by British Rail, back in 1960. It was retired only five years later, as diesel and electrification consigned the age of steam to history.

Building an engine and using it for only five years is a great way to waste investment. Which is why there's a raging debate today about stranded assets in the fossil-fuels business. Given the planet's diminishing capacity to absorb greenhouse gases without potentially catastrophic environmental effects, there is an implied cap on how much more oil, gas and coal can be used (absent some major breakthrough in carbon-capture technology). And, as happened with the Evening Star, rival ways to power transportation threaten to overturn the internal combustion engine's dominance. So producers increasingly face questions about whether some of their oil and gas reserves will ever actually be produced -- with obvious implications for their stocks.

Royal Dutch Shell Plc released a report on Thursday designed to address such concerns. The company estimates that 80 percent of its proved oil and gas reserves will be produced by the end of 2030. Given that's only 12 years away, the thinking goes, the bulk of the value in Shell's upstream business looks pretty safe even if more of our energy use begins to transition away from fossil fuels through the 2020s.

It's a position held widely in the oil business and is valid -- but only up to a point.

One essential piece of context here is that Shell's reserves-life (proved reserves divided by annual production) is notably shorter than for its rivals, especially for oil:

Shell's Oil Isn't Stranded Now But Tomorrow Matters More

Of all the majors, therefore, Shell just naturally has a more robust argument on proved reserves not getting stranded; hard to strand what you don't have. 

That said, the company also says three-quarters of its proved-plus-probable reserves -- a more ambiguous gauge of what's underground -- should be produced by 2030. This points us toward a thornier aspect of the debate.

Probable reserves, undeveloped reserves and resources are all other components of an oil major's valuation. And their value rests on investment to bring them to the surface and onto markets. Over the past decade, the big five Western majors generated a collective $1.5 trillion of cash flow from operations. But four out of every five of those dollars were plowed back into the business:

Shell's Oil Isn't Stranded Now But Tomorrow Matters More

Which is why Shell's 80 percent figure is useful but doesn't capture the full risk profile. It would have much greater significance if oil majors were simply run as sunset businesses, with most of their cash flow distributed to investors.

As it is, however, they are very much going concerns with large capital expenditure budgets that will be adding to proved reserves year-in, year-out. The question this raises is that even if 80 percent of Shell's proved reserves at the end of 2017 are apparently safe for the next 12 years, what proportion will be when we get to, say, 2022?

This isn't a question to be argued over merely at the extremes in terms of whether oil demand keeps growing for decades or is about to fall off a cliff. Valuations ultimately rest on returns, not sheer quantities of oil and gas (Saudi Aramco, take note). Look back at that chart of cash usage and it should be clear why returns began to falter years before prices crashed in 2014, as costs, capex budgets and balance sheets swelled. 

In Shell's defense, its other strategic moves align with this reality. The company is on an efficiency drive to make it resilient even in a "lower forever" oil-price scenario, and is investing in natural gas and its downstream businesses to extract more value from its production and customer base. The other majors are also doing this to a greater or lesser degree, as well as investing in shorter-cycle sources of oil and gas such as shale, partly to enhance flexibility if demand trends shift.

The point is that, in a more competitive global energy market, the amount of oil and gas on the books today is only part of the equation for value. What matters more is how much margin can be squeezed out and what the majors do with that money.

The recent crash offers a timely reminder that these businesses were built for growth. Consumption of oil and gas didn't drop, but even marginal changes in the balance of supply and demand was enough to induce a slump in prices and existential angst. Assets can be stranded not just by hard caps on consumption, but the more familiar and mundane challenge of weak economics.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

To contact the author of this story: Liam Denning in New York at ldenning1@bloomberg.net.

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