Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) announced another round of divestments in order to keep leverage under control, even as oil prices have rebounded a bit in recent times. These modest divestments are countercyclical and hurt production quite a bit in relation to the proceeds. At best, cash outflows come to a standstill this year following these moves, although they result in a smaller business going forward, while investors see dilution of the shareholder base in order to sustain the unsustainable dividend.
The moves to issue stock at historically low levels, and divest assets at a time of low prices impact the total returns which investors see over time. Value is destroyed only to preserve the dividend track record while leverage continues to be elevated in both absolute and relative terms. This unsound capital allocation strategy continues to be a red flag in my eyes.
Shell announced a fairly sizable divestment, selling 206,000 net acres of oil and gas properties in Canada in a $1.04 billion deal. Roughly, three-quarter of this deal tag is comprised out of cash and the remainder in stock. The sale will reduce pro-forma production by nearly 25,000 barrels of oil-equivalent per day in terms of liquids and natural gas.
This divestment followed multiple other smaller asset sales in recent weeks and months. In September, Shell sold a 70,000 barrel refinery in Denmark for $80 million. In August, Shell sold Brutus/Glider assets in the Gulf of Mexico for $425 million. These assets produced roughly 25,000 barrels of oil-equivalent production per day as well.
The three deals announced during the quarter will raise roughly $1.5 billion for Shell, a drop in the bucket.
Addressing The Leverage Issue
Shell continues to battle leverage issues following the ¨early¨ purchase of British Gas. The company ended the second quarter with $15.2 billion in cash as total debt stands at $90.4 billion. This net debt load of $75 billion is large as the $1.5 billion proceeds from recent asset sales will only reduce the net leverage position by 2%. The $75 billion net debt load generously excludes liabilities resulting from pensions, totaling another $16 billion.
Production totaled nearly 3.6 million barrels of oil-equivalent per day in the second quarter, as the recent $1.5 billion divestments will reduce this by roughly 1.5%. This indicates that the value received for the assets in relation to production is not that appealing as Shell loses 1.5% of production for a mere 2% reduction in net debt. It should be said that these assets, both shale in Canada & Gulf of Mexico, tend to have a higher cost of production.
In the second quarter, when WTI averaged $45 per barrel, Shell managed to post operating earnings of $1 billion. After adding back $6 billion in depreciation charges, EBITDA runs at $28 billion per annum. With net debt standing at $75-$90 billion, depending if you take pension-related liabilities into account, leverage ratios are seen at 2.7-3.2 times. Capital expenditures totaled $5.8 billion in Q2, offset by $6 billion in depreciation charges. This suggests flat net investments, not taking into account asset sales.
The issue remains the $0.47 dividend, which has to be paid out on 8 billion shares following the BG deal, at a cost of $3.8 billion per quarter, or $15 billion per annum.
If Shell reports operating profits of a billion per quarter at a time when WTI averages $45 in the second quarter, improvements can be expected in Q3. A $5 jump in WTI could boost pre-tax earnings by roughly a billion a quarter, suggesting that operating profits could run at $8 billion a year. If we take into account a gross debt position of $90 billion and taxes on profits, there is very little to nothing left for shareholders.
Depreciation charges run at a rate of $24 billion per annum, largely offset by $22 billion in terms of capital spending. This $2 billion cash flow will furthermore be aided by divestments, such as the moves reported during Q3. Given the net divestment and asset sales, Shell might be able to free up $10 billion a year from divestments into the business. This cash is much needed amidst lack of earnings as the dividend bill runs at a cost of $15 billion per annum.
It should be said that the introduction of scrip dividend makes that not all these dividends have to be paid out in cash. Roughly, 50 million shares were issued in Q2, with a valuation of little over a billion, as investors elected shares over cash. That suggests that actual cash dividend payments run close to $10 billion a year. These cash requirements will be provided by asset sales and net divestments, allowing the overall company to be cash flow neutral this year.
While the outflow of cash is halted this way, divestments will hurt the operations of course at some point going forward. Production is likely to fall, as capital spending is cut in a big way, while the issuance of scrip dividend causes dilution at a rate of 2-3% per annum.
Cash Flow Neutral, Yet Operations Are Shrinking
The analysis above shows that Shell can be cash flow neutral in this environment, but it comes at a price of 2-3% dilution in terms of the shareholder base each annum, as production undoubtedly will come down. Recent divestitures, which were announced in Q3 alone will hurt production by 1.5%. Continued cuts in regular capital spending, combined with additional asset sales, will continue to pressure production.
Combined with a lack of profitability in a $50-$55 world, time does not work in Shell's favor unless oil prices recover in a meaningful way. The company is furthermore hampered by relative high-cost production, high debt and high dividend commitments. This is unlike shale players, which have lower cost of production and have relative expensive currency in terms of stock. These players are happy to issue new stock in order to boost production, limiting a potential recovery in oil prices.
In this oil market in which quality, in terms of cost of production is more important than quality, Shell seems disadvantageous versus emerging competition. This observation and large legacy obligations continue to cast doubt on the future production, earnings potential and the dividend outlook. Strangely enough, I still feel that a cut in the dividend might be rewarded by investors, giving the company much-needed financial flexibility.
Cutting capex and selling assets in this environment is dilutive, while the scrip dividend results in the issuance of quite some stock at low levels. The relentless focus on dividends hurts the ability to countercyclically invest/make smart financial capital allocation decisions. While the goal to preserve the dividend track record might be important to management and some of its investors, it may hurt the total shareholder returns at the same time.
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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.