On Jan 20, 2014, we downgraded Europe’s largest oil company Royal Dutch Shell plc (RDS.A) to Underperform from Neutral. Our revised investment thesis is supported by a Zacks Rank #5 (Strong Sell).
Why the Downgrade?
Following Shell’s fourth-quarter profit warning, we see the integrated player as a risky bet that ordinary investors should exit.
The Hague-based Shell has cautioned investors that hike in exploration costs, lower oil and gas output, along with weak performance by the company’s refining unit, will adversely impact its fourth quarter results.
We are also concerned about Shell’s relatively heavy downstream exposure, which leaves it less diversified than its integrated peers. As such, the group’s results remain greatly exposed to refining/marketing margins. Shell’s downstream operations have struggled recently due to weak demand for fuel, leading to lower returns in this segment.
As usual, we remain worried about Shell being the most gas-focused among the major companies in the sector, with more than half of its current production from the commodity. Given natural gas’ volatile fundamentals, this remains a key area of concern, in our view.
Finally, Shell projects investment of more than $40 billion in 2014, quite high by industry standards. This is expected to substantially increase the group’s leverage and deteriorate its credit metrics during the current downturn. Additionally, the increasing capital intensity of its operations may result in reduced returns going forward.
Stocks That Warrant a Look
While we expect Shell to perform below its peers and industry levels in the coming months and see little reason for investors to own the stock, one can look at Swift Energy Co. (SFY), Linn Co. LLC (LNCO) and Warren Resources Inc. (WRES). These U.S. upstream energy operators – sporting a Zacks Rank #1 (Strong Buy) – have recorded solid growth and have the potential to rise significantly from the current levels.