When I think of oil-giant Royal Dutch Shell (LSE: RDSB) (NYSE: RDS.B.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
1) Cyclicality
If you’re in the business of finding and producing oil and gas, as Shell is, it’s a pursuit with an end product that has little pricing power and zero product differentiation. The firm’s profitability relies on the prevailing price of the commodity it sells into the market, whether that is in the upstream or downstream areas of its operations.
That makes the firm vulnerable to the effects of the supply and demand equation, which can affect trading results as the price of the commodity rises and falls as it pleases:
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| Year to December | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 |
|---|---|---|---|---|---|---|
| Revenue ($m) | 458,361 | 278,188 | 368,056 | 470,171 | 467,153 | 451,235 |
| Net cash from operations ($m) | 43,918 | 21,488 | 27,350 | 36,771 | 46,140 | 40,440 |
| Adjusted earnings per share (cents) | 509 | 160 | 304 | 461 | 432 | 266 |
I think the table shows the cyclical dip in cash flow and profits that occurred in 2009 as the company’s fortunes followed the macro-economic tide.
Despite operational progress that the firm may make, Shell has little control of the inherent cyclicality in its industry and that could jeopardise results for revenue, cash flow and, ultimately, the dividend returns for investors.
2) Dangerous operations
Drilling for oil is a dangerous business. We only need to look across at the firm’s rival BP and its 2010 Gulf-of-Mexico disaster to see how a drilling accident can financially cripple even a major oil company for years.
Shell takes similar risks to BP on a daily basis and because accidents don’t happen every day, it’s easy to become complacent about that. However, man’s ingenuity won’t always defeat the forces of nature and the next big oil disaster could be just around the corner. That’s one reason for big oil companies to sit on relatively low P/E multiples in my opinion.
What now?
Despite such concerns, Royal Dutch Shell seems set to perform well, financially, during 2014 and beyond. As such, the firm looks like a decent bet in the resources space for those investors seeking dividend income.
