THE WALL STREET JOURNAL: Shell's cash hoard may signal it plans to make a foolish deal: "Shell remains unloved and unrewarded.": "Shell's oil reserves are still too low and investors worry it will try to solve this with a large, splashy deal -- like buying Canada's Encana, a $44 billion company. Shell promises it won't. But such denials aren't believed because Shell is amassing a huge war chest.": Friday 28 October 2005

Shell remains unloved and unrewarded. Is that fair? The oil giant has recovered its poise after the Phil Watts affair. It has just delivered a solid set of results, despite severe storm damage from Hurricane Katrina. (See related article.) But it still has problems, not least the chunky valuation discount it suffers relative to peers.

The reason for this discount is easy to find. Shell's oil reserves are still too low and investors worry it will try to solve this with a large, splashy deal -- like buying Canada's Encana, a $44 billion company. Shell promises it won't. But such denials aren't believed because Shell is amassing a huge war chest.

While other oil firms, like BP and Conoco, are funneling excess cash back to shareholders, Shell is being stingier. In the third quarter, it generated $3.3 billion in free cash, beyond planned dividends and buybacks. That has left Shell's gearing at only 9%, compared to its target gearing range of 20% to 25%. If it were to close this gap, it could easily pay out another $10 billion to investors. Instead it continues to pile up cash. Why?

One reason could be higher capital expenditure, which Shell has said it will raise from the current $15 billion a year to some new but as yet unspecified level. Or, just as likely, it could be a big deal. In this case the two really are interchangeable. Citigroup estimates Shell's finding and development costs are around $13 per barrel of oil equivalent. That's around the same price at which oil firms are being bought for at the moment.

It may be that Shell needs more cash for capital expenditures -- but not so much that it doubles the current capex rate. As for deals, it's not clear that a cash pile is even necessary. Shell's newly unified share structure gives it a currency for large acquisitions; alternatively, it could raise cash through a share issue.

It all boils down to rebuilding trust. In which case, the way forward is simple. To win greater confidence from investors, Shell should hand over more of its cash.