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Shell shocked

1 August 2013 By Kevin Allison

Disappointing results at Royal Dutch Shell partly reflect an outdated way of thinking. Oil majors have long obsessed simultaneously about reserve replacement, production growth and profit. The Anglo-Dutch energy giant’s decision to ditch its production goals shows it’s wising up.

The $3.6 billion decline in replacement-cost profit from the same period last year disappointed investors. The oil major’s shares fell 5 percent by midday in London, wiping out $10 billion of market value. The biggest drag was a $2.1 billion impairment in Shell’s upstream exploration and production business, mostly from a writedown in North American shale. Shell also suffered from unusually high drilling costs in the quarter, as well as currency swings and production disruptions in Nigeria.

The environment for oil majors is tough these days, and Shell is not the only big energy company that overpaid to get in on the U.S. shale boom. But its writedowns illustrate the pitfalls of chasing barrels over profit. The oil major has decided to drop a target of boosting output from last year’s 3.3 million barrels a day to 4 million by 2017-2018. Instead, it will focus on profitability.

The shift is a response to big changes in the energy landscape. A decade ago, it made sense to focus on building reserves. Investors paid up for companies that did not shrink potential future production. There were many opportunities for companies to expand reserves, and with oil prices rising there were few worries about profitability.

Now, though, the steady rise of national oil producers has excluded western majors from most low-cost prospects. They have been forced into difficult places like the Arctic, where drilling costs are high and governments are unpredictable. In this tougher environment, companies which obsess about keeping up reserves and production are more likely to make bad investments.

Investors may be disappointed with Shell’s dud quarter, but the company is at least acknowledging the new reality. The company’s less crude approach to growth – so to speak – should produce fewer writedowns, higher profit margins, and more cash in shareholders’ pockets. If so, the day’s pain will have been well worth it.

 

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