Okay, I know this will be controversial, but I really have just sold my shares in Shell (LSE: RDSB) (NYSE: RDS-B.US). In this article I will explain why.
A company’s recent share price is based on its past profitability. A company’s future share price is based on its future profitability. So far, so obvious. The thing is, Shell recently has been hugely profitable, making nearly £17 billion of net profit last year. I think it is the most profitable company in the FTSE 100.
Profits are falling
But its current profits are falling. Full-year profits are expected to be 23% down on last year, and the trend in profitability is clearly downward.
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The sudden, sharp fall in profitability has taken me, and many other investors, by surprise. Let’s analyse why this is happening.
Shell has invested substantially in gas, particularly liquefied natural gas (LNG). Yet, as more and more shale gas has been produced, the gas market has been over-supplied far more quickly than anyone expected, and gas prices have tumbled. Rather counter-intuitively, the shale gas boom has been detrimental to conventional gas producers.
Peak oil is now reality
What’s more, as the realities of peak oil hit home, with exploration costs increasing and oil production falling, Shell’s profits from oil are also falling. And the strengthening pound means the currency-adjusted oil price is also falling.
Some might argue that Shell’s new chief executive is ‘kitchen-sinking’ all the bad news in this quarter, but I very much doubt that this is the case. The company’s difficulties are more deep-seated and structural.
If we look across the oil and gas industry, we see profitability falling across the board. BP‘s profits have also tumbled, as have BG‘s. These difficulties are not a one-off, and neither are they restricted just to Shell.
In the light of the recent profit warning, Shell’s P/E ratio is now 12. I would say this is neither overly expensive nor particularly cheap. And there are also positives: LNG demand is steadily increasing, as Shell’s investments bear fruit. The gas price won’t always be this low, and I suspect gas will make up an increasing proportion of Shell’s profits. Gas still represents Shell’s best bet on the future.
Foolish bottom line
But, overall, I have turned more negative on the whole oil and gas sector. My view is that Shell’s shares won’t crash, but neither will they bounce upwards. So I have sold my shares in Shell and invested in higher-growth shares.
This brings me back to my point about the past and the future. Because Shell has been such as consistent and highly profitable performer in the past, people expect it be so in the future. But the reality is that the oil is running out, and gas prices are falling. The overall picture is complex and rapidly evolving, but what I can say is that the oil and gas industry is experiencing a period of rapid and dramatic change. It will need to adapt quickly.
