Shell

Two weeks ago Shell Transport & Trading (SHEL) announced full year earnings for 2004, bringing to an end a year of mixed messages for investors. On the one hand, there was controversy surrounding the reclassification of the company's oil reserves and on the other there were record profits. In the end, the oil reserve updates instigated a senior management shake up and corporate restructuring.

Shell's net income for the year came in at an astonishing US$18.5 billion, a record for a British company. Contributing to this stellar performance were fourth quarter earnings of US$4,478 billion, a 134 percent increase over 2003. The company's return on average capital employed (ROACE) also rose significantly from 15.5 percent in 2003 to 20.1 percent.

The oil major's financial position was strengthened significantly by robust operating cash flows on the back of higher oil prices. Shell's cash position increased by US$6.5 billion to US$8.5 billion, while gearing fell from 20.9 percent in 2003 to 13.7 percent. This high level of cash generation will enable Shell to return US$10 billion to shareholders via dividend payments as well as re-launch a US$3-5 billion share buyback programme this year.

Oil and gas production volumes of 3.8 million barrels of oil equivalent (boe) per day were down slightly from 2003 but towards the high side of previous guidance. We are pleased to see production volumes are expected to remain between 3.5 and 3.8 million boe per day through 2006 offering Shell leverage to continued strength in the oil price.

We were however disappointed to learn that Shell's fifth cut in reserves in the past 12 months would be 1.4 billion boe. This latest reduction takes the company's proven reserves down to 12.95 billion boe. We are confident however that Shell's thorough review and involvement of external consultants will enable the company to now draw a line under this reserve controversy.

With a lower reserve base now in place, we believe it is imperative that Shell works to improve the company's reserve replacement ratio (RRR). In 2004, Shell expects the firm's RRR to be between 45 and 55 percent before year-end price impacts and divestments. The company is targeting 100 percent replacement over the 2004-2008 period. In order to accomplish this objective, we are heartened to see Shell targeting US$15 billion per annum in capital expenditure over the next several years. Nearly US$11.5 billion of this will be earmarked for exploration and production investments.

The company's corporate restructuring into a single entity, Royal Dutch Shell plc, is expected to be completed by July. We are pleased to see the two companies taking this historic step in their organisation as we believe the previous dual structure may have contributed to the reserve downgrades. In our opinion, the new entity should yield more accountability and transparency in the decision making process, not to mention the cost savings the company should unlock as a result of less bureaucracy and duplication of various support functions.

We consider Shell's current valuation as attractive with the shares trading on a 2005 price earnings ratio of 13.5 times, while offering a respectable dividend yield of nearly 3.5 percent. We believe the market has now priced in Shell's reserve downgrades. We maintain that the company's simplified structure will yield positive benefits by enabling better decision making while also producing cost savings. In addition we expect earnings growth to be underpinned by a more aggressive exploration programme and ongoing strength in the oil price.

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