Status Update

Mar 28, 2019

Slides

Welcome to the IFRS Webcast on the 28th March 2019. There will be a presentation followed by a Q and A session. I would like to introduce the first speaker, Mr. Chair Huizinga. Good. Thanks a lot. Good afternoon. Ladies and gentlemen, welcome to the Shell's webcast on the impact of IFRS 16. I'm Cherek Hausikau, the EVP of Investor Relations for Royal Dutch Shell and I'm joined today by Martin Timblink, our EVP Controller. Before we start, let me highlight the disclaimer statements. Today, we would like to explain to you the impact of the implementation of IFRS 16. This new accounting standard has significant implications for how our financial results are reported and we are keen to talk you through these implications ahead of our Q1 results. We will also cover the impact on our financial statements and some of our key metrics. The figures which follow are unaudited and some figures or conclusions represent estimates of future effects and may be impacted by business or other changes. Martin will do a short presentation covering IFRS 16, what it means for Shell and how we have adopted the new standard. Then at the end, we will open the call for Q and A. Let me now hand over to Martin. Thank you, Cerg, and good afternoon, everyone. As Cerg mentioned, IFRS 16 has a material impact on Shell's financial statements and metrics. I will explain these impacts over the course of this presentation. However, let me start by pointing out that this new accounting standard does not change the way we do business and has no impact on our net cash position. And we will continue to apply the same discipline when we decide whether to lease or buy an asset. Now as reported in our 2018 annual report, which we published earlier this month, we have recognized an additional lease liability of some US16 $1,000,000,000 and that's reflected on our balance sheet at January 1, 2019, as a result of the IFRS 16 change. With effects from quarter 1, 2019, you will see a shift from operating expenses and charges in purchases to depreciation and interest expenses on the income statement. Similarly on the cash flow statement, we will see a shift from both cash flow from operating and cash flow from investing activities to cash flow from financing activities. Now let's first focus on the key changes introduced by IFRS 16. In short, IFRS 16 eliminates the distinction that existed between an operating lease and a finance lease. Under the previous standard, operating leases were held off balance sheet and finance leases reported on balance sheet. On the IFRS 16, all leases are now reported on balance sheet. IFRS 16 offers a number of adoption approaches and practical experience. Let me run through the chosen approach for Shell. Firstly, naturally, we have adopted the standard with effect from January 1, 2019. And we have chosen the modified retrospective approach rather than the fully retrospective approach. Now under the modified retrospective approach, the cumulative effect of initially applying the standard is recognized as of January 1, 2019 and there is no restatement of comparative information. We have chosen this transition approach for practical reasons. At January 1, 2019, we recognized an operating lease liability, which is equal to the present value of the remaining lease payments, discounted using an entity specific incremental borrowing rate. I'll come to that in a moment. At the same date, we recognized the right of use asset equal to the lease liability and adjusted for items such as onerous lease provisions and lease prepayments that we carry on the balance sheet at the end of 2018. Short term leases, meaning leases with a contract tenure of 12 months or less, will continue to be held off balance sheet as allowed by IFRS 16. We chose not to adopt an exemption for low value leases. We, however, continue to apply materiality cutoff principles in our financial reporting and lease reporting is no exception. Now where contracts contain both a lease and a non lease component, we have chosen to apply IFRS 16 to the lease component only, not to the combination of both. Examples include lease contracts with a maintenance service element. The service element is a non lease component. So let's now turn to the substance of Shell's lease portfolio. We lease a wide range of assets across our different businesses. And to give you some insight, we carry over 10,000 contracts classified as a lease. As reported in our 2018 annual report, our total future operating lease commitments at end of 2018 was US24.2 billion dollars on an undiscounted basis. These assets include ultra deepwater drilling rigs to conduct exploration and production activities, LNG vessels to carry out our trading and shipping activities, retail sites to service our customers, office buildings to house our employees, etcetera. And the size of our lease portfolio is significant and we are aware it's larger than some of our peers. So how did we translate the undiscounted future commitments into the lease liability that we carry on the balance sheet? We used a set of incremental borrowing rate assumptions to discount all operating lease commitments onto the balance sheet on January 1, 2019. Now 3 considerations determine the rates used per contract. The first one relates to the nature of the assets. We differentiate rates according to the classes of assets, namely ultra deepwater drilling rigs, LNG vessels and other assets. And other deepwater drilling rigs and LNG vessels attract higher borrowing rates than other assets due to their very specialized nature. And the second consideration is the tenure of the lease contract. We apply differentiated rates for lease tenures of less than 10 years and of 10 years and longer. And then finally, the rate applied to the contract reflects the credit rating of the Shell entity holding the lease contract. Now this works out at a weighted average of 7.2% at January 1, 2019. And that's the rate which applies at transition. Now you will see that per segment, the weighted average rates are somewhat different and higher for upstream due to the ultra deepwater rates they operate and in integrated gas due to the use of LNG vessels. After January 1, 2019, new lease liabilities will be recognized using the borrowing rate implicit in the lease contract. Unless of course, that rate cannot be determined, in which case, we'll use the latest set of incremental borrowing rates that applies. And we will review those incremental borrowing rates or rate assumptions on an annual basis going forward. Let's now compare the commitment of US24.2 billion dollars which we reported in our 2018 annual report with the $16,000,000,000 liability recognized on January 1. And not surprisingly, the discounting effect, the €5,200,000,000 that reflected there is the largest. And that's determined by the incremental borrowing rates that I have experienced just a moment ago. Now we also have some leases that haven't commenced yet and that's the 2nd largest effect reflecting US2.6 billion dollars And these basically represent lease contract commitments for which the asset is not getting used and hence the liability does not exist at this point. And then finally, short term leases not recognized on balance sheet on the balance sheet represent a small amount of US0.3 billion dollars Now let me reiterate that the 7.2% is the weighted average incremental borrowing rate on transition. This is not an indication of the borrowing rate to be expected on future lease contracts. So, let's then turn to the impact of IFRS 16 on some of our key financial metrics. Now let's start off with gearing and gearing is expected to increase by some 4% to 5% as the operating lease liabilities are now brought onto the balance sheet and will therefore increase our net debt. Operating expenses are expected to go down by some €2,000,000,000 to €3,000,000,000 as operating lease expenses are now reported as depreciation and interest. As explained earlier, IFRS 16 will have an immaterial impact on our earnings. However, there will be a shift of earnings between segments. Corporate segment earnings will include the interest expense on operating leases and you will note that up to 2018 corporate earnings already included interest expense on finance leases and the business segment earnings will include the depreciation related to operating leases. So if you compare 2019 with 2018, corporate earnings will be lower year on year due to the additional operating lease interest expense and business earnings segments will be business segment earnings will be higher year on year as the depreciation charge in 2019 will be lower than the operating expense or the charge to purchase that we saw in 2018. The total increase in interest expense for the corporate segment is expected to be around US1 $1,000,000,000 Although there is no effect on the cash amount paid by our businesses for leased assets, there will be a change to where these payments are presented on our cash flow So as the lease payments will be reported on the cash flow from financing activities, this will result in a higher reported free cash flow as you can see on the slide. In total, we expect this effect to be about US4 $1,000,000,000 per annum. Now following the adoption of IFRS 16, capital investment will increase. It will increase by about €1,000,000,000 to €2,000,000,000 as not only finance leases will be included, but also operating leases with effect from 1st Jan, 2019. Now in order to improve the transparency of our capital expenditure and the continued discipline we will maintain on capital expenditure will supplement our reporting of capital investments with information on our cash capital expenditure going forward. As we are bringing more liabilities onto our balance sheet, our capital employed will increase and our team CCS ROACE will consequently go down by about 0.5 percent point. With effect from quarter 1 2018, we will bring the way we calculate our clean CCS ROACE more in line with our peers by adding back the after tax interest expense to the clean CCS earnings. This is important as the effect of IFRS 16 would accentuate the misalignment between peers and ourselves. And as Gerd mentioned in his opening comments, these figures are unaudited and some of the figures or conclusions represent estimates of future effects and maybe impacted by our business activity or other changes. But overall, they should give you a good indication of the impact that we are expecting. Now let's turn to the impact of the recognition of operating leases on our financial statements. And this slide tries to bring it all together. Now important to point out this excludes existing finance leases and associated right of use assets and liabilities which are unchanged under IFRS 16. And details on those finance lease positions are available in our 2018 annual report. To reiterate, we do not expect the impact of IFRS 16 on RDS earnings to be material. Looking forward to 2019 and the impact of IFRS 16 on our income statement, we expect to report additional depreciation of US2 billion dollars to US3 billion dollars and additional interest expense of about US1 $1,000,000,000 Instead of similar amounts on the operating expense and purchase lines under the old standard. Looking at the cash flow statement, there is no impact on our net cash position, but we do expect a shift of about €3,000,000,000 to €4,000,000,000 from CFFO and up to €1,000,000,000 from CFFI to CFFF. And over to the balance sheet, I explained the principles of the adoption entries early in this presentation and then let me quickly run through the amounts. On balance sheet days of January 1, 2019, we recognized an operating lease liability of US16 $1,000,000,000 and the associated right of use assets we recognize is US15.6 billion dollars and that's after netting of the certain items from the lease liability amount. First of all, we reduced the right of use assets by any provisions, any existing provisions on onerous contracts by about €1,200,000,000 and then the right of use asset is increased by any prepayments we've made on leases and that's about €900,000,000 on the balance sheet as of the end of 2018. And then finally, the right of use asset has to be reduced because we have to recognize that a small amount of these assets are subleased and that's about €100,000,000 In 2019, you will see us reporting our key financial indicators, both on a pre and post IFRS 16 basis as well as a number of transition disclosures. This ensures you can continue to compare our performance with prior periods and also track us against guidance that we've provided previously. This will start in quarter 1 of this year and run until the end of 2019. At management will be consistent with IFRS 16 and from the basis of our communication with the market going forward. So let me try to recap. IFRS 16 has a material impact on Shell's financial statements and financial metrics. A lease liability of €16,000,000,000 will be brought on to the balance sheet and the lease costs will shift from operating expense and purchase to depreciation and interest expense. However, IFRS 16 does not change Shell's strategy, nor its financial framework and has no cash impact. With that, let me pause and go for your questions please. Thank you. We will now begin the question and answer And we'll first go to Irene Himona with Sogen. Thank you. Good afternoon. It's Irene Himona to Societe Generale. A question of clarification, please. For operating leases, for those assets which Shell operates itself, do you have to include 100% of the operating question, Irene. The information we provided today reflects our question, Irene. The information we provided today reflects our interest share. This is an item which was put forward to IFRIC and IFRIC recently concluded we have to yet assess the impact of their conclusion. Their suggestion is that we would need to recognize 100% irrespective of our own interest share. We'll go next to John Rigby with UBS. Thank you. Yes, like two questions. So first, just a follow-up on that question Irene asked. So what you're saying is, I think if I understand it, that that is still an outstanding item to be resolved. Is that correct? And if it is, are you able to say how much the effect might be of a grossing up exercise within your books? The second question, I guess, is sort of is raised from the disclosure you make. If I take what you say on face value, I think sort of implies that given your raising CapEx, the reported CapEx guidance is that there is the intention to continue to be taking assets onto the balance sheet using leasing. But rate in those leases is significantly greater than the borrowing rate that Royal Dutch Shell Corp the corporation could achieve as one of the sort of strongest balance sheets in the sector. So I'm curious why you would even be using operating leases as a way of funding the business when it looks optically anyway to be so expensive? Thanks. Good questions. John, let me try to come to both of them. Indeed, that of as it goes against the one of the fundamental principles of the oil and gas industry where an operator and being an operator should not be worse off or better off relative to the venture partners, I. E. All the venture partners share in the liabilities and in the assets of the venture. In terms of They understand that by the way. They understand that, they appreciate that. That would seem to be a reasonable contention. Yes. That's a very reasonable contention, something that we have described in our response to them and they haven't taken it on board. So it could potentially have wider implications, which is why we need to review the decision of IFRIC including with our external auditors. In terms of potential impacts, our initial indications are that that may have an additional lease liability of €2,000,000,000 to €3,000,000,000 associated with it. That is a very broad brush figure, John. So please don't quote me on that. On your second question, so why would we use leases? I think we need to make a distinction between the IVR that we apply the incremental borrowing rate that we apply on transition, which in a way we have constructed based on logical set of assumptions versus what is a effective interest rate in a lease that we may enter into going forward. Those decisions are made on economic value considerations and indeed we have a relatively lower interest rates as RDS. So it will need to be the flexibility that is offered by the lease construct. It may be the other services that are brought into the lease that we can't necessarily procure ourselves in that same way or at the same commercial terms. So the consideration is always an economic one and always one that involves our Treasury Department, who have clearly an interest to keep a close eye on this. Super. Thank you. We'll go next to Lydia Rainforth with Barclays. Thank you. And two questions as well. Well, just to follow-up on John's point around the optically that interest rate looks expensive. Is there any way for you to be able to go back and have a look at those leases and reopen them to try and reduce that interest rate? And then the second one, probably more for Cherk around the free cash flow definition. Clearly, you're showing that the free cash flow in the IFRS 16 rules will be about $4,000,000,000 higher. Is can I just ask why not change the free cash flow definition to be able to give us more of an indication of what is available for shareholders? Thank you. Why would we so first of all, the incremental borrowing rate that we apply a transition is a constructive grade. That's part of this what we describe as a modified retrospective approach. In terms of the economic decision that we have taken, we will have satisfied ourselves that it was the logical economic rationale to enter into that lease. So going back to renegotiate contracts is really not doesn't come into play in any way, I would say, Lydia. Yes. Lydia, on your question on the free cash flow, as we've said and Martin has said earlier as well, for this year, we will keep reporting on both the old basis and the new basis so we can have the comparison. That's also because we will not restate 2018. So I think on the free cash flow, yes, that will be SEK4 1,000,000,000 higher. As we have already highlighted in Q4 and we're highlighting now as well, at Management Day, we'll look at all the various definitions and that's what we have said here as well. Going forward, we will use the IFRS numbers and therefore, the management day outlook will be based on the IFRS 16 numbers. So we are looking at all of these different KPIs and what will be the effect, but we're giving you now the numbers, but we also will give during this year, we will give the old basis as well. So you can compare like with like both on free cash flow and also the other areas including the capital investment. So there will be not a difference there versus the targets which we have given at Management Day 2017. Understood. Thanks. Does that answer your question Lydia? Yes, it does. Understood. Thank you very much. Okay. Next question. We'll go next to Christopher Kuplentes with of America. Thank you. Three questions if I may. Firstly, I'm aware that a few rating agencies have said, of course, for some time, we've taken all these off balance sheet liabilities into account already. But in preparing these numbers, in the process of preparing these numbers that you're presenting today, have you had additional conversations with credit rating agencies or are you assuming that for them this is an absolute nonevent? Secondly, 2 follow-up questions briefly. On IFRIC, do you have an estimate when they will come to a resolution that will force you to revisit the numbers you've presented today on a 100% working interest basis? And 3rd follow-up, and I appreciate, Chuck, this is probably more one for you, why not take this opportunity and actually present cash flow from operations, let alone free cash flow post net interest expense? Thank you. All good questions. I can probably address all 3 of them, Christopher. So with regard to the rating agencies, we have regular contacts and engagement with the rating agencies. They are well aware of the lease portfolio that we carry the associated commitments. And I don't believe this will fundamentally offer their perspective on the rating of RDS. And turning to IFRIC, they have made the decision only, I believe, as recently as a week ago. And so this is relatively hot off the press. Hence, why we still need to consider the implication of their decision. And we will need to take some time, particularly because of the potential implications for other liabilities. That's a real concern for us, and we'll need to understand how IFRIC came to this position. Choice to report interest payments either on the CFFO or CFFI. And we take a view that these payments logically flow through should logically flow through CFFS as they are of a financing nature and not an operating nature. And we also are mindful of the fact that the ISB is considering a change to IAS 7 and that will require IFRS reporters to report interest payments on the CFFF in future. And that would remove the optionality that currently exists. Really from a reporting perspective, there is no overriding reason to change our presentation at this point in time. Yes, Christian, that last answer is really important because clearly, we know from the market about these questions and we've been looking into this. But especially this thing which Martin has just said, bunch of potential that this will change would make us change now and then change again. And that's clearly not what we want to do. Finally, you can find these lines very clearly in the cash flow anyway. So we know it's not aligned with everyone, but this could be a change and therefore we don't have before some change at the later stage. Makes sense. Thank you. And at this time, there are no further questions. I'll turn the call back to Chair Heisinger. Okay. Well, if there are no further questions, I think that is great. And we really hope this is useful, and we'll seek your feedback back on that later. As you all know, our Q1 results will be announced on the 2nd May and we hope many of you can join us there as well. So thanks a lot, and we'll speak to you later and especially on the 2nd May. Appreciate it. This does conclude today's conference. We thank you for your participation.