The news flow on Royal Dutch Shell PLC (LSE:RDSB, Financial) in recent days has been fascinating. I wrote recently about why I own BP PLC (LSE:BP., Financial) because I see it is better situated for the energy transition that we are living through.
In essence, I saw that BP had at least one year’s head start over Shell, and it was showing a bigger commitment to transitioning its portfolio for the new energy landscape we are approaching with decarbonization in mind.
Reading a lot of commentary in the U.K. press made me realize why many commentators are commentators and not professional investors. The consensus from the U.K. business pages seems to be that Shell CEO Ben Van Beurden’s strategy is correct and Daniel Loeb (Trades, Portfolio)’s idea is not practical. James Li has given a good summary of Third Point’s investment in Shell. You can also read Loeb's s comments on the Shell investment in his quarterly letter.
As outlined in his letter, in essence, Loeb wants Shell to do the following:
Optimize Shell’s corporate structure to reduce cost of capital and allow it to more aggressively invest in decarbonization.
Match its business units with unique shareholder constituencies who may be interested in different things (return of capital versus growth; legacy energy versus energy transition).
Allow each of its business units to more nimbly and effectively react to market and environmental policy developments.
Shell and some investors have pushed back on this idea, saying that Shell’s legacy asset cash flows are needed to fund the growth businesses. Or that while on a spreadsheet the idea looks good, in reality “there are complex synergies at businesses that are pretty tricky to untangle”
Really? I don’t think so. This is just talk from lazy management and lazy investors who don’t want the status quo to change. Most managers are interested in the size of their business and resist breakups.
But the practical issues about Shell breaking up are not that problematic. Loeb’s plan is possible and would create shareholder value. The company's current strategy is on course to build a huge energy conglomerate, which would bring with it a massive conglomerate discount.
First of all, this has been done before. In 2012, the refining and marketing business Phillips 66 (PSX, Financial) was spun off from oil major ConocoPhillips (COP, Financial). Both stocks performed better than the energy sector in the following years thanks to both businesses becoming pure plays with respective managements having better focus.
A closer look at Shell
Currently, Shell six business units: Marketing, Refining & Trading, Chemicals, Integrated Gas, Renewables & Energy Solutions and Upstream.
Marketing is the service stations and customer business. Refining & Trading holds the refineries, shipping and trading units. Integrated Gas is predominately liquified natural gas, while Renewables & Energy Solutions is its nascent electricity business and Upstream is oil exploration, development and production.
From a financial reporting point of view, it has four segments: Oil Products (made up of Marketing and Refining & Trading), Chemicals, Integrated Gas (made up of Integrated Gas and Renewables & Energy Solutions) and Upstream.
In May, Shell disclosed a new financial reporting arrangement that will come into effect next year. There will be five distinct segments: Marketing, Renewables & Energy Solutions, Chemicals & Products, Integrated Gas and Upstream.
Shell is saying it will have three strategic pillars: growth (Marketing and Renewables & Energy Solutions), transition (Chemicals & Products and Integrated Gas) and finally upstream.
Loeb hasn’t specified exactly how he would want Shell split up, but he suggested a simple legacy and new company. Legacy would be Upstream, Refining and Chemicals (a traditional integrated oil & gas company), while newco would be Integrated Gas, Renewables and Marketing.
But there are many ways to skin this cat. BP recently sold its Chemicals business, so the division could be a standalone business. Refining and Marketing would naturally go together, like a Phillips 66 or Valero Energy (VLO, Financial). Shell’s Renewables & Energy Solutions division is still quite small, so attaching it to Integrated Gas would make sense and this would be a low-carbon business.
Shell’s argument that an integrated business (an energy conglomerate) makes more commercial sense doesn’t really fly from a shareholder value perspective. Yes, there are some synergies, but there are also management dis-synergies at present. As ConocoPhillips successfully showed, you can split up an integrated oil and gas business successfully. As for intersegment business, these can be replaced with commercial contracts in competition with the wider market. When Refinitiv split from parent Thomson Reuters Corp. (TSX:TRI, Financial), Refinitiv agreed to pay Reuters News $325 million a year until 2048. Something similar could be done with Shell if need be.
A carbon-intensive company like upstream can be run down for cash. For instance, a negative growth company whose sole responsibility is to return cash to shareholders. The newco business can operate as a growth business where investors expect earnings to be aggressively reinvested and dividends are not required.
Ultimately, Loeb’s argument is broadly correct. The details can be worked out depending on what investors want and the best combination of Shell’s assets, operations and managerial capabilities. But I believe Shell could be split into two or three separate businesses and they would produce a sum-of-the-parts value greater than the current conglomerate structure.
I’m not sure if Shell will break up. Loeb may fight for a while, like he has done at other activist campaigns and walk away with profits, but without the company following his advice. That’s why I prefer BP; I think they are on the right track. If Shell’s position on the break-up changes, then I believe there will be a lot of upside in that situation.
