Upstream energy companies have taken quite a beating over the first quarter of 2016, thanks to record low crude oil prices. Brent Crude hit its $31 low back in January, and as earnings results came in over the last couple weeks, it became readily obvious to me that the carnage was widespread. Even the big integrated names took it on the chin, financially.
Royal Dutch Shell (NYSE:RDS.A) is no exception. Shell has adamantly clung to its dividend since the downturn started, and the company's balance sheet has suffered as a result. On April 15th Moody's downgraded Shell from Aa1 to Aa2, and outlook remains negative. It's not too hard to see why that is.
Cash flow and earnings
Excluding results from BG Group (whose assets were not with the company in the year previous), Shell's production was down about 1% year-over-year in Q1. Over the quarter, Shell generated $1.6 billion in earnings. Upstream posted a loss of $1.4 billion (down from a loss of just $0.2 billion last quarter). Integrated gas tacked on $1 billion in earnings, and downstream added $2 billion.
Cash flow numbers better reflected realized prices. This quarter Shell generated only $661 million in operating cash flow, but had to spend $5.3 billion in capital expenditure, and another $2.3 billion in dividends, putting the company about $7 billion in the hole for just the quarter. Clearly, things can't go on like this for much longer before further credit downgrades hit the company.
Thankfully for Shell, Brent Crude has recovered from about $31 per barrel to $49 per barrel today. That's going to make a big difference in cash flow numbers next quarter. But will Shell break even? I still doubt it. If previous quarters with realized crude prices to those of today are any indication, I suspect Shell will still carry a deficit of between $2 billion and $3 billion in Q2, which is roughly the size of the quarterly dividend.
How long Shell can sustain itself like this depends upon how much damage to the balance sheet management is willing to inflict. I believe that Shell needs Brent Crude in the high $50s, at least, to be cash flow neutral with the current dividend. As Shell has continued lowering both operating costs and capex needs, I suspect that 'breakeven' might come down a bit, perhaps by a couple dollars per barrel.
For example, last quarter alone Shell took another $1 billion out of operating expenses, reducing costs 20% year-over-year. Shell has also exited a sour gas plant project in Abu Dhabi, and has deferred its British Colombia LNG project and a floating LNG project off the coast of Australia. As Shell integrates its backlog with BG Group, I expect further 'high-grading.'
In the meantime, Shell's debt to trailing EBITDA ratio sits at 3.14 times, according to data from Morningstar. That's well higher than Exxon Mobil (NYSE:XOM) at about1.25 times, and Chevron (NYSE:CVX) at about 1.8 times.
Some closing thoughts
Will Shell be able to keep its dividend? That's looking less and less likely as time goes on. I'm not sure whether management is willing to withstand a multi-notch downgrade of its credit rating. It is true that crude has rallied over the past couple weeks, but that could easily be tentative. If crude drops into the low $40s and stays there for a year, then I don't believe the dividend lasts more than two more quarters. In which case, shares would really drop.
Things will get better for Shell during Q2, but I expect the cash drain to continue until Brent Crude into the high $50s. I also suspect that Shell will have to maintain around $25 billion in capex in 2017 and beyond to maintain production levels. Much of Shell's legacy assets are in decline and Shell will have to tap into BG's project backlog.
I recommended Shell back on November 25th, 2015, citing that I believed the dividend would continue for long enough before crude recovered. Today I am not so sure, and so I no longer recommend buying or even holding this stock. Don't let yourself get enticed by the 7.4% dividend yield. Shell's dividend is on ground which is shakier than that of Exxon and Chevron.
I continue to steer clear of most E&Ps at this time, and Shell has to be on that list due to the present cash flow situation. If you are interested in Shell, feel free to follow me on Seeking Alpha. I write articles regularly on this company, and will provide update articles when the situation is material and relevant.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.