Royal Dutch Shell (NYSE:RDS.A, RDS.B) outlined a plan at its recent strategy update to manage the difficult environment in the downstream segment, an environment that the CEO of the company called the "weakest" in 20 years. The company will sell non core assets and continue its cost cutting. We'll look at the general plan meant to turn the company into a lean, profit-generating machine.

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Rough Shape
The poor operating conditions were caused by the addition of capacity that was planned several years back when margins were higher, along with a fall in demand for finished product due to the recession. This has reduced the return on average capital employed (ROACE) for Royal Dutch Shell in the downstream segment to the low single digits. This is far below the five-year average ROACE of approximately 12%. Royal Dutch Shell has decided to embark on a three pronged plan to improve profitability in the downstream.

Losing Weight
The company will sell some of its assets in the downstream that the company considers to be non-core. This will necessitate exiting 15% of its refining capacity by 2012, and 35% of its retail marketing operations with the intent to refocus the downstream segment into areas that yield the highest return.

The marketing portfolio of the company is diverse and operates in more than 100 countries, and Royal Dutch Shell feels that the best way to boost returns is to exit areas where it sells smaller volumes of product.

Refined Plans
Royal Dutch Shell will continue on its cost cutting efforts in the segment which has yielded billions in savings over the last few years. Last of all, Royal Dutch Shell will invest selectively in larger and more complex refining operations that the company hopes will capture higher margins. The Nelson Index, a scale used to determine the value added by a refinery, will measure this complexity.

Royal Dutch Shell is continuing the expansion of a refinery that it operates in Port Arthur, Texas. The refinery will have capacity of 600,000 barrels per day when the expansion is complete.

Other large refineries in the United States include the Baytown refinery in Texas owned by Exxon Mobil (NYSE:XOM) with a capacity of 573,000 barrels per day, the Texas City refinery owned by BP (NYSE:BP) with a capacity of 456,000 barrels per day, and the Pascagoula Refinery in Mississippi owned by Chevron (NYSE:CVX) with a daily capacity of 330,000 barrels per day.

Following Through
Royal Dutch Shell made good on its word, and just two weeks after announcing its plan in the downstream segment, the company reached an agreement to sell its New Zealand marketing operations for $492 million. The company is also reviewing its retail marketing, lubricant and commercial fuels businesses in 21 African countries for possible sale . Analysts estimate that the sale will yield as much as $1.5 billion in proceeds.

Bottom Line
Royal Dutch Shell is not alone in facing a harsh business environment in the downstream segment, and the company's plan to reduce its portfolio and focus on higher return areas where it has scale and a technological advantage seems the correct one. (For more, see our Oil And Gas Industry Primer.)

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