How Safe Is The Dividend Of Royal Dutch Shell?

Summary

• Royal Dutch Shell has not cut its dividend since World War II.
• However, its dividend growth rate has been lackluster at best during the last decade.
• Its dividend payout ratio is remarkably high while its net debt has almost doubled during the last 4 years.
• On the other hand, the company intends to sell $25 B of assets this and next year.

While Royal Dutch Shell (RDS.A) (RDS.B) has retrieved half of its losses since it bottomed early last year, it is still 25% lower than its peak three years ago, just before the collapse of the oil price began. As the downturn in the oil market has already lasted longer than initially anticipated, with no light on the horizon yet, the shareholders of the stock are still in pain. Therefore, given that the generous dividend of the stock is the only consolation to the shareholders, it is important for them to evaluate how safe the dividend is.

First of all, the stock currently offers a 7.1% dividend yield, which is the highest among the oil majors. Even more impressively, the company has not cut its dividend since World War II. Therefore, it is only natural that most shareholders are holding the stock for its reliable and growing dividend. As a result, the stock will plunge if the company cuts its dividend.

On the other hand, while the dividend growth record is exceptional in duration, the growth rate has been lackluster at best during the last decade. More precisely, the company has raised its dividend by 2.2% per year on average during the last 5 years and 2.7% per year during the last decade. Moreover, while the current 7.1% dividend yield is certainly attractive, such a high yield usually signals that the dividend is at risk of being cut in the near future. Otherwise, the market would not offer such a high yield, particularly in the prevailing environment of almost record-low yields. Nevertheless, Shell and BP (BP) have already maintained an extraordinary dividend yield for 3 years and may continue to do so despite the adverse business environment.

A concerning issue for Shell is its remarkably high dividend payout ratio, which has been much greater than 100% in the last 3 years and currently stands at 200%. In addition, the free cash flow has been much lower than the annual dividend payout of about $10 B in the last two years. Moreover, the company has almost doubled its net debt in recent years, mostly due to its acquisition of BG Group. To be sure, its net debt (as per Buffett, net debt = total liabilities – cash – receivables) has climbed from $88.0 B in 2012 to $156.3 B this year. Therefore, the oil major cannot continue to add debt to support its extraordinary dividend for many years.

Even worse, while the price of oil posted a strong rebound since it bottomed early last year, it has recently faced renewed pressure. The reason is that the rebound has led numerous shale oil producers back to production mode and this new output has offset the production cuts implemented by OPEC. To make a long story short, the US oil production is approaching its all-time high once again and hence OPEC seems to have lost its pricing power. This does not bode well for the oil price, which is likely to remain under pressure for the foreseeable future.

It is also worth noting that the management of Shell has emphasized that its first priority is to reduce the debt while it is only its second priority to maintain the dividend. This is in sharp contrast to the stance of the management of the other oil majors, which have claimed that their first priority is to maintain their dividend.

On the bright side, the management of Shell expects significant production growth within the next three years, as new projects will start to contribute to the total volume. More specifically, the management expects about 400,000 barrels/day new volume within the next three years. Nevertheless, while this is certainly positive, we have witnessed such optimism from other oil majors as well, such as Chevron (CVX), and reality proved markedly different from the management’s forecasts. The reason is that the managements tend to focus only on the positive side (new fields), while they fail to mention the natural decline of the existing fields. As the natural decline of the old fields tends to be significant, it usually offsets most of the new output. Therefore, it will be interesting to examine whether the optimistic view of the management of Shell materializes or the natural decline will limit the actual volume growth.

While most of the above facts do not bode well for the dividend, Shell is likely to maintain its dividend for at least another 2-3 years. The key is that the company intends to sell about $25 B of assets this and next year. It has already announced the sale of $15 B of assets while it is determined to sell another $10 B. As the annual dividend amounts to $10 B, these asset sales will be sufficient to cover the dividend for the next 2-3 years. Therefore, Shell is likely to follow the paradigm of its peers, i.e., maintain its current generous dividend via extensive asset divestments.

Finally, it is worth mentioning a source of risk for oil producers, which their shareholders should certainly have in mind as long as the oil price remains suppressed. More precisely, the oil industry regulator of Norway recently raised safety concerns in North Sea, as the number of incidents rose to a 5-year high. This is an important notice for Shell, which is a dominant player in the area. As long as the downturn of the oil market persists, oil producers will continue to struggle to squeeze as much profit as possible and will probably make compromises in the safety of their procedures. As a reminder, the greatest accident in the history of the oil industry occurred in Macondo when BP tried to expedite its project by a few days to save approximately $0.5 M per day. While the probability of another major accident is very low, the consequences of such an accident would be severe for the shareholders and hence the latter should keep this risk factor in mind.

To sum up, as the oil price is likely to remain suppressed for the foreseeable future, the earnings of Shell are likely to remain under pressure. On the one hand, the high dividend payout ratio and the huge debt pile do not bode well for the dividend. However, on the other hand, the management is determined to maintain the current dividend for at least another 2-3 years via substantial asset sales and possibly the issuance of a limited amount of debt. Therefore, a dividend cut is not likely in the near future.

Analyst’s 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.