With the BG acquisition in the books, Shell (RDSB) is embarking on the necessary steps to compete in a world of $60 a barrel oil. Like the rest of the integrated group, Shell is working to reduce its cost base, which has become bloated during the past five years, by reducing headcount and improving its supply chain. The integration of BG is integral to Shell’s efforts, as it holds the potential for $4.5 billion of cost-reduction synergies. Furthermore, the addition of BG’s low-cost production reduces Shell’s per-barrel operating cost, which ranked among the highest in its peer group. In total, Shell aims to reduce operating cost by 20% from 2014 levels by the end of 2016, with further reductions possible in later years.
At the same time, Shell plans to dramatically reduce investment levels as new projects are completed by capping yearly capital spending at $30 billion through 2020, versus the nearly $50 billion it spent in 2014. The sharp decrease should improve capital efficiency, but should not completely sacrifice growth. While the reduction in spending is in part a function of canceled marginal projects that are no longer economical, it also results from cost deflation, improved performance, and design standardization, which have meaningfully improved potential returns and reduced total project spend.
The impact is most notable in Shell’s future deep-water projects in the Gulf of Mexico and Brazil, where break-even levels have fallen to $45 a barrel. The improved economics of deep-water projects, combined with projects nearing completion, high-return conventional reinvestment opportunities, and a large LNG portfolio, which does not decline, mean it can deliver modest growth at a reduced level of spending.
What Next for Shell?
As a result of its collective efforts, including divestiture of capital-intensive, low-return upstream and downstream assets, Shell should boost margins and improve returns by 2020, leaving it in a better competitive position. However, while we do not forecast the firm to achieve its goals of 10% return on capital, it can realize its $20 billion in free cash flow target with oil of $65 and some additional cost-cutting that returns upstream costs to 2011 levels.
