Why Shell will benefit from this major global challenge

The world’s population is forecast to increase from 7.3 billion today to 9.7 billion by 2050. That’s a rise of 33% in just 34 years and this brings a significant challenge. That is how to balance the increased energy needs of a larger population of people with a required reduction in carbon dioxide emissions. Shell is on-track to become a leading light in this arena. Therefore, I believe it has a very bright long-term future.

A changing business

Shell (LON:RDSB) is intent on responding positively to the challenge of a higher population and a requirement for lower carbon dioxide emissions. In this sense, it is a rapidly changing business. Its acquisition of BG Group is perhaps the best evidence of this. BG adds significantly to Shell’s LNG capabilities and makes Shell the world’s biggest trader of liquefied natural gas (LNG). Although LNG is a fossil fuel, burning LNG emits 30% less carbon dioxide than oil and 45% less carbon dioxide than coal for an equivalent amount of heat.

However, Shell is not about to become a pure play LNG producer. It is investing in other technologies as it becomes a lower-carbon energy producer. For example, it is now one of the world’s largest suppliers of low-carbon biofuel through its Raizen joint venture in Brazil. This produces ethanol from sugar cane. Shell’s lubricants also offer improved energy efficiency for motorists, while its increased offering of LNG as a transport fuel will help to diversify its low carbon offering yet further.

In addition, Shell is investing in carbon capture technology (CCS). In the medium to long term the range of industries for which it will be available is set to increase. Already, Shell‘s Quest facility captures and stores a third of the annual carbon dioxide emissions from an oil sands bitumen processing facility in Canada. This could act as a blueprint for similar systems in the coming years.

Innovation potential

Clearly, new technologies require significant investment. On this front Shell is well-placed to remain at the forefront of low carbon technologies. Its acquisition of BG is forecast to produce synergies of $4.5 billion in 2018. This will boost Shell’s free cash flow so that it is around $20 billion – $25 billion per annum by 2020, assuming oil trades at $60 per barrel. This compares to free cash flow of $3.7 billion in the 2015 financial year.

Although some of this higher free cash flow will be diverted to paying a high dividend, in my view much of it could be used to fund further innovation and investment in low carbon technologies. That’s particularly the case because Shell yields 7.2% at the moment. This indicates that dividend rises could be slow in future years without upsetting income investors among the company’s shareholder base.

Similarly, Shell’s balance sheet can accommodate greater debt to speed up the development process. Shell’s net debt to equity ratio was 47% as at 30 June 2016. Shell’s debt servicing payments were covered 23.5 times by operating cash flow last year which provides further evidence of its higher leverage potential.

Oil play

For many investors, however, Shell is an oil stock and oil equates to a short-term problem. That’s because the price of oil is unlikely to rise before the end of 2017. At least that’s the view of the International Energy Agency (IEA). Their Executive Director, Fatih Birol, stated this week that the glut in supply of oil will continue until towards the end of 2017, as demand fails to increase sufficiently to balance higher supply.

Even though a deal has been struck between Opec members to limit supply to just below the current level of 33 million bopd, there is still a glut of supply which will take time to be reduced due to sluggish demand growth. This means that the oil price may fail to continue its recent recovery over the next couple of years.

Oil prospects

However, Shell isn’t a pure play oil company. Oil is expected to become less important to Shell because of the company’s increasing focus on LNG and other low carbon technologies.

Of course, the oil price is unlikely to trade at sub-$50 per barrel in the long run. In my view it will rise in the long term thanks to falling exploration expenditure and a continued importance as part of the energy mix in developing nations.

In fact, the IEA estimates that over $25 trillion of investment will be needed in oil and gas supply alone from 2015 to 2040. Due to the current low price of oil, there could be a lack of incentive for companies to invest in projects that are needed to ensure long-term supplies.

Without this investment, demand may end up exceeding supply in the long run. With oil and gas combined providing over 50% of the world’s energy needs, it seems likely that they will both remain key parts of the global energy mix over the next decade. This is good news for Shell as its transition away from oil and towards lower carbon technologies continues.

Outlook

Shell is focused on becoming a low-carbon energy producer. Therefore, it is natural that LNG, carbon capture and other cleaner technologies will become a bigger part of its business than oil. In my view, over the medium to long term the oil price will start to matter less to Shell’s financial and share price performance.

In the coming years, Shell will evolve into a more nimble company. It will become more about innovation rather than production, and investment rather than dividend payouts. In this sense, Shell is changing rapidly and due to its financial strength, new strategy and an improving adaptability to the changing demands of the world energy market, it is well placed to deliver high returns.

The challenge of higher energy demands from a rising population combined with a requirement for lower carbon dioxide will not be easy to overcome. But Shell is on track to lead the way in this space. For that reason, it has investment appeal in my opinion.

Disclusure: Robert Stephens, CFA, owns shares in Shell at the time of writing.