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Shell's payout: little margin for error

The low oil price is putting the squeeze on the biggest dividend payer on the London market. Will it have to make a historic cut?
July 14, 2017

Policy: “To grow the US dollar dividend in line with our view of the underlying earnings and cash flow of Shell”

Yield: 7.1 per cent

Payment: Quarterly, declared in dollars, paid in sterling (class ‘B’ shares)

Last cut: 1945 (as Royal Dutch)

IC TIP: Buy at 2,079p

Strictly speaking, a dividend yield above 7 per cent should be a red flag to investors. It’s the market’s way of saying future returns are in doubt. For Royal Dutch Shell (RDSB), this has been a familiar refrain ever since the oil market said goodbye to $100-a-barrel prices in 2014, and serious questions concerning the oil major’s commitment to shareholder returns started to grow.

Every company in this feature returns considerable sums to investors, but Shell’s total payout – equivalent to $15bn (£11.6bn) a year, including cash and scrip payments – is the highest of any London stock by a country mile, and makes an outsize contribution to the dividends of FTSE 100 tracker funds. Investors hold Shell in their portfolio for two key reasons: the centrality of fossil fuels to the global economic engine, and the company’s consistency at rewarding shareholders. On the latter front, Shell can hardly be bettered; unlike peer BP (BP.), the group has held or increased dividends every year since the Second World War.

On balance, we think this record is likely to continue for at least the next couple of years. But the margin for error is thin, as the dividend has been insured by corporate actions to divest “non-core” assets over the past 18 months. By the end of the first quarter of 2017, Shell had announced (if not completed) disposals equivalent to around $20bn, theoretically providing enough cash to meet shareholders’ expected returns. As we argued when first-quarter results were published in May, the fact that the company’s $3.9bn total dividend was technically covered by free cash flow of $5.2bn might be something of a mirage. Indeed, shareholder returns were only just below the $4.3bn capital expenditure in the period, which was well below the amount needed to maintain medium-term production goals.

 

In other words, it’s a strategy, but not one that necessarily supports a sustainable dividend in a lower-for-longer oil price scenario. Take, for example, HSBC’s forecasts for the company over the next three years. In 2017, analysts at the bank expect operational cash flow to hit $36.6bn, rising to $41.3bn next year and $45.5bn in 2019. Of course, that’s enough to fund cash dividend commitments of $10.8bn, $13.4bn and $15.7bn, respectively, although this also assumes the oil price will creep up on a nice straight line to $70 a barrel by 2019.

What if it doesn’t? What if US shale producers continue to flood the market with supply, and Brent crude lingers at $50 a barrel? HSBC has modelled that scenario, and believes Shell will be slightly free-cash-flow negative from 2018 onwards, leaving very little in the way of remaining funds after capital expenditure and interest payments. This tightrope will face further stresses: management has announced its intention to suspend scrip dividends – that is, shares issued in lieu of cash dividends – once Shell’s gearing is closer to 20 per cent. Plugging that gap will require $4bn of cash a year. Throw in long-term liabilities including a $10bn pension deficit and around $20bn of future decommissioning costs, and Shell’s income case looks pressured.