Green energy investing in an unlikely place

This recommendation is probably going to be a little controversial. I’ve found an oil company that sees the writing on the wall and is committing to tapering off its upstream oil exploration and production activities in order to fund green energy projects and transition to a green future. Purists will dislike that the company will remain a net emitter of carbon for decades. I see a pathway forward to a near term future where billions are spent by industry per year on green projects instead of the few hundred million we see now.

I intend to show that this transition essentially guarantees the company will earn a low risk 12.5% in share holder return per year for decades while deleveraging their balance sheet and reducing litigation and regulation risk. I suspect when the competition sees what this move does for their bottom line, there will be a rush to replicate the model. This is how we get trillions of dollars in investment capital redirected from fossil fuels to renewables.

I think it is also important to note that the abrupt death of the petrochemical industry would likely meant an equally abrupt end to modern civilization. The goal should be to stop burning carbon for energy, not to eliminate the many uses of oil such as: fertilizer, plastics, lubricants, waxes, advanced materials, napthenes, and more. I for one, don’t want to live in a world without propylene oxide.

Today’s recommendation is Royal Dutch Shell (RDS-B), herewith known simply as “Shell”. Shell is an integrated oil and gas major that has made a commitment from the most senior levels of management to cut exploration and production capex to, in part, fund green electricity generating projects. At the same time, the company will deleverage the balance sheet, reduce commodity pricing risk, and return cash to shareholders via dividends, and share buybacks. I will show here how this will realistically result in decades of shareholder returns greater than 12.5% per year.

All six of the oil majors have at least some green energy projects in the works. For five of the six, these efforts are just window dressing and marketing. For Shell, it is a material real money commitment to a greener (and more profitable) future. Traditionally, in the oil production game it is understood a company needs at least 10 years of reserves to sustain its market share. Shell has been letting reserves wind down and is now at about 8.5 years of reserves and still declining. This is not a matter of drilling dry holes. Management has committed to reducing capital expenditures on new exploration. The upstream oil and gas business is being left to dwindle away for strategic reasons. In 2018 new production consumed 51% of Shell’s capex. By 2025 it will only be 41%.

That is a substantial pile of money. Some of it will be returned to shareholders (and that is a huge part of why this is an attractive investment.) But at the same time, some will be directed towards transitioning Shell into a greener company. It won’t be a full Solar company any time soon. Instead it will focus on the broader chemical space that transforms napthenes and paraffins into useful chemicals rather than burning hydrocarbons for fuel. It will also begin to build out a solar electric generation business. The resulting company will have a radically smaller carbon footprint and better economics.

Let’s look at numbers. In the most recent reporting year, Shell had $382 Billion in revenue. It earned 49 Billion in cash from operations. It put 23 Billion back into the business leaving 26 Billion in Free Cash Flow (FCF). FCF can be thought of as “owner earnings”. It is what the company can use to buy other companies, pay dividends, pay down debt, or buy back stock. Consensus estimates are that Shell will produce 23 Billion of FCF in 2019 and 26 Billion in 2020. For oil drilling, the economics might look like this: The company produces oil for 30 dollars and sells it for 60. But the oil is now gone forever and must be replaced so there is new exploration costs of about 16 dollars. Your net profit is then a slim 14 dollars a barrel. Shell is going to reduce that 16 dollar spend to boost profits and power alternative investment.

Shell is forecasting $65 Billion in annual cash flow and 30 Billion in capex for the foreseeable future, leaving 35 Billion in FCF. That is an approximate 35% growth in FCF available to be returned to owners. At the same time, the company will begin spending about 2.5 Billion per year in new utility scale solar generation projects. What’s better, is the company has committed to returning 125 Billion to shareholders over the next 5 years. With a market cap of 230 Billion, Shell will be return about half its value to shareholders!

Shell currently returns 15.5 Billion per year in dividends. That number will probably stay about the same with the rest coming as share buybacks. The math is compelling. Shell is going to return about 30 Billion per year via buybacks. With the current market cap at about 230 Billion, you can expect your stake to grow by more than 12.5% per year. And that is without any bonuses Shell picks up in renewable tax credits, carbon trading profits, or improving fundamentals driven by becoming less exposed to oil and gas commodity pricing. The competition is plowing its cash back into an oil industry that simply does not exist in the future. As this becomes evident to the market, I expect Shell to soar. I also expect that a rising share price will prompt management to accelerate its plan to defund its exploration activities and double down on greener initiatives. This is how the world goes from spending a few hundred million on renewables a year to 20 to the 30 billion a year we need for a meaningful transition. Purists will decry that Shell will remain a net carbon polluter for decades but I think management deserves praise for being forward looking and changing from being the problem to part of the solution. All without wrecking the global economy by removing essential chemicals, plastics, lubricants, paints, varnishes, and more from the market.

ACTION TO TAKE: Buy RDS-B up to 65 dollars a share.

Shares as of this writing trade for 59.57 and yield an impressive 6.4% annually. This yield is slated to grow as the company keeps its payout steady but reduces share count (dividends per share must then grow!) Plan to hold your shares for the long term. Advanced traders can write covered calls on each 100 shares they own, targeting an expiry of about 8 weeks and annualized (bonus) return of 1.5%.

–Lizard King–