Anglo-Dutch oil and gas supermajor Royal Dutch Shell PLC has made several strong strategic statements about its plans to address the energy transition--the long-term structural change in energy systems--especially over the past 12 months. Shell is the only supermajor that aims to disclose, and ultimately reduce, Scope 3 or end-user greenhouse gas emissions to support a low carbon future. Shell plans to increase its investments in new sources of energy to up to $3 billion per year from $1 billion-$2 billion currently, and was the first company to link its executives' pay to carbon-emission targets.

Shell aspires to become one of the top players globally in power--a combination of electricity distribution, power generation, and retail--and has already made several acquisitions to this end. At the same time, the reported reserve life of Shell's core, cash-generative, upstream oil and gas business continues to decline. In this Credit FAQ, S&P Global Ratings answers investor questions about how we view Shell's commitment to the energy transition from a credit quality prospective.

Frequently Asked Questions

How does S&P Global Ratings view Shell's materially lower reserve life than that of its peers?

Shell's reserve life under SEC guidelines--calculated as 1P proved reserves divided by production--has ranged between eight and nine years over the past three years, trending lower than the 10 years we usually see among its peers. Although this metric is a comparative weakness for Shell, we are comfortable with Shell's ability to maintain at least flat production over the next 10 years and beyond. Moreover, in our base-case scenario for the next three-to-five years, we forecast that Shell's production will grow by 1%-3% per year.

In addition, Shell's production from new projects is generating more profit thanks to a reduced cost base, supporting an improvement of the cash flow breakeven level from $58.9 per barrel of oil equivalent (/boe) in 2018 to $52.0-$54.0 in 2019, and below $50 thereafter. (The cash flow breakeven price is the price at which operating cash flow covers capital expenditure [capex] and dividends.) In general, we consider a company's disclosed 1P reserve life a useful indicator of the sustainability of its future cash flow generation, although we also seek to understand the context and any material technical reporting factors, and assess complementary metrics.

Shell has a solid pipeline of projects for the next five-to-seven years and does not account for all of them as 1P. The company has meaningful proved undeveloped reserves, which, if added to 1P proved reserves, would increase the reserve life to nine-to-10 years. Shell does not disclose its 2P reserves, but these are large, and the conversion rate from 2P to 1P has been solid historically. That said, if the reserve life declines further to seven years or below, this could lead us to reassesses Shell's overall business risk profile, as it could signal a material difference in Shell's capacity to sustain production compared to that of its peers.

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We also think that Shell's weaker reserve life than that of its peers is offset by the strength and diversity of its cash flow generation, as its downstream, lubricant, and retail operations should reduce the volatility of its cash flows compared to other oil and gas majors that focus more on exploration and production.

How will Shell's greater focus on the energy transition affect its credit fundamentals?

Shell's exposure to environmental risks, especially climate change, will remain very high over the next 10 years and beyond, as for the oil and gas sector as a whole, because oil and gas upstream and downstream activities will dominate profits and cash flows. Although Shell aims to increase its spending on new energy sources to up to $3 billion per year from $1 billion-$2 billion currently, this will still account for only 10% of its capex. From a cash flow generation perspective, the contribution of new energies to consolidated cash flow will remain even more modest in the next five-to-10 years. Moreover, we believe it will be challenging for Shell to find targets that meet its requirement for an 8%-12% return on capital employed, and its actual investments could be even lower than its target. Shell's approach to new investments has been prudent to date, and we assess the risk of material losses compromising the overall cash flow generation as low.

We continue to see Shell's diversity as a key strength, as the company's large refining, chemicals, and retail operations should mitigate the volatility of commodity prices. Over the next five-to-10 years, these business segments, along with traditional upstream activities, are likely to generate large cash flows, giving Shell time to roll out profitable new energy businesses. Importantly, Shell allocates capital to diverse new energy models, and has businesses in wind, solar, hydrogen, retail, power, and other segments. From this perspective, Shell's early engagement with evolving energy trends could be beneficial in the long run, giving it a competitive edge over peers, notably in the U.S.

For more information on our approach to environmental, social, and governance factors for the oil and gas sector, see "ESG Industry Report Card: Oil And Gas," published June 3, 2019, on RatingsDirect.

Why do reduced gas prices have less impact on Shell than on its peers with similar shares of gas?

In our assessment, Shell's overall share of gas sold, one way or another linked to oil, is higher than for its peers. In 2018, around 60% of Shell's liquid natural gas (LNG) sales are long-term oil linked contracts. While we expect a further transition of oil-linked contracts to gas hub-based ones, this process is gradual, and migration to hub prices will take many years.

In addition, Shell has a materially larger gas trading business than the other supermajors. Shell has the largest fleet of LNG vessels among its peers, which allows it to provide truly global coverage of LNG. Lower gas prices and rebalancing of regional price premiums create arbitrage opportunities, which Shell uses and will continue to use.

Is Shell's shareholder remuneration policy sustainable in the context of the energy transition?

In our base-case scenario, we assume that Shell will complete its $25 billion share buyback program by the end of 2020. With oil at $55-$60/boe, we think that Shell has the capacity to achieve this target and still maintain funds from operations (FFO) to debt of 50%-60%, which is commensurate with the current rating.

At the same time, we do not believe that Shell will raise dividends meaningfully in the coming years, as otherwise it might be unable to achieve its goal of reducing gearing from 25% currently, including the impact of International Financing Reporting Standard No. 16. Shell recently updated its financial policy and aims to maintain gearing within the 15%-25% range and to reduce absolute debt further from the current $92.6 billion.

What is the highest rating that Shell could achieve with its existing business model if its credit metrics continue to strengthen?

We believe that both upside and downside on our 'AA-' long-term issuer credit rating on Shell are fairly unlikely in the next year or so. In the longer term, Shell's decisions on shareholder remuneration and mergers and acquisitions will be the key factors supporting potential ratings upside.

We think that Shell could achieve a long-term issuer credit rating of 'AA' or 'AA+', which is what we rate its U.S. peers Chevron Corp. and Exxon Mobil Corp., respectively. For that to happen, Shell's FFO to debt would need to remain above 60% through the cycle. The rating would be determined by the headroom that Shell had under this FFO-to-debt threshold; its relative sensitivity to commodity prices; and our assessment of its financial policy on shareholder returns and balance sheet management under different price scenarios.

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