Energy: Powerful Production

Following extreme Q1 winter conditions across a majority of [Southwest Gas unit] NPL Construction Co.'s operating areas, management had remained cautiously optimistic of flat to positive year-over-year 2014 results; however, NPL Q2 net income declined approximately 4% year over year, weighing on SWX's consolidated results. While full NPL details are not available until the 10-Q, we suspect higher labor costs (overtime, etc.) may explain some of NPL's ongoing headwinds.

Total system throughput of 39.4 million dekatherms declined approximately 6% year over year due to warmer year-over-year conditions. Specifically, heating degree days (HDDs) across SWX's service territories were about 1% lower year over year and about 27% below their 10-year period average. However, due to its decoupled rate designs & customer additions, the utility still posted a roughly 2% year-over-year rise in gross profit.

We note that SWX added some 28,000 net new customers in the trailing 12 months.

Stephen Simko, CFA
Morningstar
[email protected]
312-696-6000

Royal Dutch Shell (RDS-A, RDS-B) is an integrated energy company with operations along almost every part of the oil/gas supply chain. With production of more than 3 million of barrels of oil equivalent (boe) a day—roughly half is oil, Shell is one of the largest energy producers in the world. Refineries are predominantly located in the United States, Europe and Asia. Year-end 2013 proven reserves stood at 13.9 billion barrels of oil equivalent a day, equal to 11.6 years of annual production volumes.

Shell's narrow economic moat relies on the oil and gas resources it possesses, which included 13.9 billion boe of proven oil and gas reserves at year-end 2013.

The company also benefits from skills and expertise developed through decades of exploration and production. Shell's huge financial resources provide it with opportunities most oil and gas producers are unable to pursue (for example liquefied natural gas, oil sands and Arctic drilling).

With its large operating cash flows, the company can maintain capital spending levels through the troughs of commodity price cycles. All of the oil majors remain highly leveraged to oil prices and therefore benefit from OPEC's ability to maintain a floor in oil prices.

We are raising our Shell Class B fair value estimate to $74 per American Depository Receipt (ADR) from $72 as we update our near-term oil price projections. Our forecasts assume Shell increases production roughly 1% annually during the next five years, although it should be noted that actual figures will be lower due to asset sales (which we do not model unless explicitly announced).

For its downstream segment, we model annual profits to range between $4 billion and $5 billion, which implies that single-digit returns on capital employed are likely to continue. The cash flow outlook remains robust, and we believe the company is well positioned to continue increasing its dividend by mid-single-digit rates each year (assuming $5 billion in asset sales occur annually as guided by management).

For oil and gas prices, our forecasts use prices based on NYMEX futures contracts for 2014-16 and our own mid-cycle price assumptions for 2017-2018. Brent oil pricing: $108 per barrel in 2014, $106 in 2015, $102 in 2016, and $100 in 2017-2018. West Texas Intermediate oil pricing: $100 per barrel in 2014, $95 in 2015, $91 in 2016, and $90 in 2017-18. Henry Hub natural gas (U.S.): $4.23 per thousand cubic feet in 2014, $3.88 in 2015, $4.03 in 2016, and $5.40 in 2017-2018.

Shell has two share classes that possess the same rights, except Class A shares are domiciled in the Netherlands, whereas Class B Shares are traded in London.

What this ultimately means is Class A shareholders must pay a dividend withholding tax, and this can only be claimed on U.S. taxable income reported to the Internal Revenue Service. In other words, tax leakage is possible (in tax-sheltered accounts). U.S. investors don't have to pay withholding taxes on U.K. dividend income, which make Shell's Class B shares a simpler proposition from a tax perspective.

Additionally, Shell's $5 billion-$6 billion in annual share repurchases can only be from Class B stock. Together, these dynamics lead to Class B shares trading at a premium (recently 3%-7%) to Class A shares.