Remco-Swiers-photography/iStock Editorial via Getty Images

Remco-Swiers-photography/iStock Editorial via Getty Images

Investment thesis: Shell (RDS.A), (RDS.B) continues to present investors with a major dilemma. It is faced with dwindling upstream reserves as well as significant costs related to internal, as well as external pressures to significantly reduce its carbon footprint. These are factors that make it an unattractive investment choice for the longer term. The shorter-term outlook on the other hand looks exceedingly good. For the next few months and perhaps the next few years as well, it is set to greatly benefit from higher oil prices, as well as the surge in natural gas prices and demand that we are seeing around the world. This includes a surge in LNG demand, which will greatly benefit Shell this winter and most likely beyond.

Shell is a global leader in LNG, making it well-positioned to take advantage of the global energy situation.

As a reflection of just how important LNG has become to Shell's overall business model. Shell currently controls about 20% of the total global LNG shipping capacity. That is in addition to many other assets it controls or is invested in that are related to producing, shipping, and receiving LNG shipments. Shell's LNG strategy has been one of the main reasons I decided to pick up some stock about half a decade ago, given the longer-term trends I saw in regards to natural gas consumption as a bridge fuel towards a low-carbon global economy. Natural gas was used in the EU for the past 30 years as a replacement for coal, with a great deal of success in helping to reduce its emissions levels.

Japan LNG spot price chart Source: ycharts

Japan LNG spot price chart

LNG prices have had a somewhat lackluster period last decade, with only the last few years, with only occasional signs of a bright future ahead. Now we have the recovery from the lows we saw during the initial stages of the COVID lockdowns. It seemed like nothing out of the ordinary at first, but just in the past month or so LNG prices started to take off. The Japanese LNG spot price tends to be a good barometer of the overall market because Japan is heavily reliant on LNG imports, given its isolation from continental pipeline networks in the region and few domestic natural gas resources of its own.

LNG prices are surging because it is the only flexible source of natural gas that does not depend on pipelines for delivery. In other words, when more gas is needed, or there are problems with pipeline deliveries, LNG can be used as a substitute. It is of course also the case that in the event that pipeline gas becomes available in abundance, LNG demand can plummet, given that in most cases it tends to be cheaper than LNG. It is therefore a very volatile commodity, but at this point, the market is headed in a good direction for LNG producers and shippers, based on long-term fundamentals that are highly favorable.

The financial impact of LNG on Shell's bottom line is not negligible. For the first half of 2021, its integrated gas segment that is mostly LNG provided just over $3 billion in adjusted earnings out of a total of $8.8 billion for the entire company. It was just slightly lower than the earnings provided by the upstream segment, which came in at $3.4 billion. In other words, LNG is becoming nearly as important to Shell as its entire upstream production, which tends to drive investor sentiment to a greater degree than any other sector within Shell's diverse portfolio.

Post-COVID recovery exposed energy supply tightness, as well as a need for more flexibility in supplies, given the growing role of intermittent sources of energy, largely dependent on weather patterns.

I find that it is important to cite one of the main root causes of the current energy crisis that seems to be spreading from Europe, across the world, because some aspects of it are not commonly cited by media institutions or by government officials. The tendency to avoid the inclusion of certain facts can have a profound effect on our understanding of the true nature of the situation. Weather patterns in Europe have been a major culprit behind the shortfall in energy that is sending ripples across the world, with the price of natural gas, coal, and oil surging as everyone is scrambling to secure supplies.

It started with a colder than usual spring that prolonged the heating season, drawing down Europe's natural gas storage levels. Meanwhile, wind patterns seem to have entered a prolonged period of less than usual intensity, where there just wasn't enough of it to generate electricity at expected levels. In Germany for instance, wind power generation declined by about a quarter in the first half of 2021 compared with the previous year. Lastly, there was less rain than usual in Scandinavia, leading to a drop in hydropower generation and exports to the rest of Europe. All of it happened within the context of a global economy firmly recovering from the COVID crisis, leading to a surge in energy demand compared with last year.

Energy prices first started surging in Europe, but then it spread elsewhere, including in Asia, where there was also a realization that the supply/demand situation looks tight. The adjustment needed to try to cover the shortfall in Europe is causing natural gas prices to surge everywhere, including in North America where a tighter supply/demand balance is also being exacerbated by higher LNG demand in Asia & Europe.

With the growth in intermittent sources of energy that are displacing other electricity sources, such as coal, nuclear as well as arguably the cleaner-burning gas, it is increasingly clear that the global energy system will need a lot of extra flexibility to shift significant volumes of natural gas from one continent or area to another, as demand factors dictate. Pipeline gas will most likely continue to provide the bulk of global supplies, but LNG needs to play a much larger role, and grow proportionally with wind & solar power generation growth rates. Shell already has a bullish view in this regard.

As impressive as the prospect of LNG growth may seem based on Shell's arguably biased view, since it is such a prominent player in the LNG space, I do believe that LNG demand growth may actually outpace Shell's own arguably positively biased expectations. The recent rise in LNG imports by China is just a recent example of just how fast demand for LNG can materialize.

Growth may be uneven as for instance, the case of China will show, where the Power of Siberia pipeline from Russia is just ramping up and at times those extra supplies may displace some LNG sales. While such factors may give the impression that global long-term LNG demand patterns will resemble the two steps forward, one step back dance, the trajectory will nevertheless be a relatively steep upward march towards more and more global prominence.

I bought Shell stock over half a decade ago, in large part because I liked the LNG component of the business, which I found will complement the rest of the business. I also liked the fact that it was focusing on downstream petrochemical investments to take advantage of low-priced shale, instead of jumping into the upstream segment of the shale patch, where investors mostly lost money. I added more along the way, most recently in 2020 as the COVID selloff provided an opportunity to buy the stock cheap. With a decent dividend throughout most of the period, and the fact that I am above water on the stock price overall, it has been a decent investment thus far.

I am worried about its long-term prospects. Between environmentalist pressures from within the company, as well as externally, the situation could potentially ruin an otherwise solid company. Its dwindling upstream reserves are also a reason to worry. It is an awkward situation, where the shorter-term outlook looks really good in terms of expected financial results, while the above-mentioned pressures provide ample reasons to be pessimistic about the long-term outlook.

At the same time, market trends are generally bullish for the oil sector for the shorter term, and perhaps beyond, while Shell's own strategy for the past decade, leaves it in a strong position to take advantage of these trends, as the LNG case highlights. My view at this point is that the long-term concerns will weigh on the stock, and it will perform below the potential that shorter-term financial results on their own would dictate.

Long-term investors will be unloading Shell stock throughout, creating a bit of a drag. At the same time, the shorter-term outlook and results are just too good for the market to ignore, therefore Shell stock should perform relatively well in the next few months, and perhaps even years.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of RDS.A either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.