Historically the deal with Royal Dutch Shell (NYSE: RDS.A)(NYSE: RDS.B) stock went something like this: in exchange for a mature business with a low growth profile operating in a cyclical sector you were typically treated to a stodgy dividend. Indeed for much of Shell’s history the average yield was around the 5% mark. In addition to that, the company managed to replace and increase its reserves base whilst paying out a large chunk of profits as dividends. This is pretty much the short version explaining how Shell managed to deliver such great long-term returns.
The other point I’d add about the Shell dividend is that it typically gives you something to hold on to when the stock isn’t up to much. Consider the past ten years; a period which has resembled something of a lost decade in terms of the share price. If you’re a UK investor you see the shares trading at £17 each back in April 2007. Fast forward a decade and the current share price is around 30% higher at £21.90.
Run the numbers over a ten year period and you’ve probably just about matched inflation. In addition, however, Shell have paid out just under £11 per share in dividends in that time. Factor that into the equation and suddenly your annual returns don’t look too bad all things considered. Needles to say if you reinvested them along the way things would look even more respectable.
Given the above it’s not surprising folks are now sweating over the company’s dividend. The situation with Shell is arguably more acute given the importance of the distribution to investors in the UK and Europe. In the former it accounts for something like 10% of the total dividend spend, and you could probably populate a small country with pensioners who look to Shell dividend to top up their income. Let’s go ahead and take a look at whether those concerns are justified.
The $50 Billion BG Group Acquisition
Between 2011 and 2015 Shell saw its reserves drop from 14 billion barrels of oil to 11 billion. Now you don’t need me to tell you the importance of reserves for an oil company, however the key issue is that during this time Shell still spent $150 billion on capital expenditures. Cashflow from operations during the period totaled $200 billion and dividend payments basically made up the difference. Balancing the need for capital expenditures to maintain reserves with the dividend is a tricky one. When the dividend is sacrosanct it gets even trickier. The mega-deal to buy BG Group’s 3.5 billion barrels of proved reserves represents a remedy for this issue. In short: more production, more cashflow, more reserves and future dividends secured.
The flip side to the deal is twofold in the short-term. Firstly, the mixture of cash and shares as the source of funding means that the share count is enlarged at a time when dividends are burdensome. Before the deal Shell had 6.2 billion ordinary shares outstanding with a dividend commitment of $1.88 per share. Post-deal the enlarged share count is now 7.9 billion with the dividend unchanged in per share terms. That gives Shell a cash outlay of approximately $15 billion per year at the current dividend per share level.
Secondly, the cash portion of the deal has naturally required the company to take on a load of extra debt. At the end of 2016 the total debt on Shell’s balance sheet stood at $92 billion. That figure may sound astronomical on its own, but bear in mind we’re talking about a company with over $400 billion worth of assets including $19 billion in cash & equivalents. How does around $75 billion in net debt and a $15 billion per year dividend commitment stack up? For that let’s look at the company’s most recent set of operating figures to get a handle on things.
Eyes On The Cashflow
In the final quarter of 2016 Shell managed to bring in $9.2 billion in operating cash flow. Its capital expenditure commitments were $6.2 billion and dividends took up a further $3.8 billion. There are, however, some additional points to consider. Firstly, around $1.5 billion was settled under its scrip dividend program (i.e. issuing new shares as dividends rather than cash). In other words cash outlay was around $8.7 billion versus cash inflow from operations of $9.2 billion. In addition Shell is selling a bunch of assets under a divestment program. This brought in an extra $3 billion in total during the quarter.
Okay, so where does this leave us going forward? First of all, Shell expect the divestment program mentioned above to reach $30 billion in total by the end of 2018. The company have recently announced a bunch of deals such as the disposal of North Sea assets, worth up to $3.8 billion, and the $7.25 billion disposal of its Canadian oil sands assets. By way of comparison total divestments made to date only come to around $5 billion ($3 billion of which was in Q4 2016). All-in-all there’s probably a further $10-15 billion yet to be realized over the next couple of years.
Ordinarily you’d think that championing the sale of assets to fund a dividend isn’t particularly smart. It’s the kind of behavior that more resembles a high risk annuity rather than a sustainable blue chip dividend payer. In the case of Shell there are a couple of mitigating circumstances though. Firstly, this kind of flexibility is fine on a short-term basis in a period of energy sector volatility. Secondly, and the more relevant reason in the long-run, the BG Group acquisition represents something of a game changer with a future emphasis on natural gas. It’s natural to expect Shell to undergo a fairly large scale strategic repositioning of its underlying business in these circumstances.
The Shell Dividend In 2017 And Beyond
Shell are guiding for capital expenditures of around $25 billion in 2017. If we assume the scrip dividend conserves cash in the same ratio as 2016 then we’re probably looking at additional cash outflow of around $10 billion on top of that. All-in-all this would leave the total outflow side of the equation at around $35 billion for this year.
My guess is that 2017 will see Shell post a material improvement on the $20 billion in cash flow it generated last year assuming oil prices stay at their current level. As a rough guide it will probably fall somewhere between $25-$30 billion. As for the sensitivity to the price of oil, every $10 change will add/subtract $5 billion to/from that figure. Factor in proceeds from the divestment program and the dividend looks covered. More importantly there should be enough left over to chip away at that rather large $70 billion net debt pile. We’ll have a slightly clearer view when Shell reports Q1 2017 results in a few weeks, although dividend growth is probably off the table for a little while. Reducing debt will take priority over the dividend should it come to that.
On a longer-term time frame there’s more to be upbeat about. There’s a bunch of projects due to come online this year, not to mention the long-term cashflow from the BG Group assets. Estimates indicate that these new projects will add a further $10 billion to operating cashflow by 2018. In a $60 per barrel oil price scenario Shell is saying it could realistically generate in the region of $20-30 billion in free cash flow by 2020 – enough to cover the dividend and tackle debt. With the shares currently yielding 6.65% I think it’s enough to make them relatively attractive over the long run.