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Royal Dutch Shell: Does Everything Come Down to Oil Price Recovery?

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By Staff Writer on Jul 19, 2016 at 9:07 am EST

World’s leading integrated oil and gas company, Royal Dutch Shell plc (ADR) (NYSE:RDS.A), concluded a deal to acquire BG not too long ago. The move was widely perceived as an aggressive step to become a dominant supplier of liquefied natural gas (LNG) across the globe. The deal is expected to help Shell diversify its operations and enable it to benefit from cost synergies in the years to come.

The merger came at a time when oil prices were on a downward trajectory, with the step expected to drive the company out of the downturn. Oil prices that were once above $110 per barrel have now plunged below $50. Last year, when the Dutch company announced the deal, many mergers and acquisition pundits criticized Shell’s willingness to pay 50% premium in a depressed crude oil environment.

Many energy companies employed counter measures to tackle the downturn, including asset sales and capital & operating expenditure reduction. The low oil price environment had wiped off billions in cash flows and revenues.

Many companies saw the low oil price environment as an opportunity to acquire companies at discounted values. Shell spent around $50 billion to buy rival BG Group in the midst of a major oil price rout.

The price of Brent has fallen by half in the last 24 months, and has pulled Shell’s operational cash flow well below the amount needed for exploration and funding dividends. The purchase of BG has filled Shell’s tank full of debt. Investors were prepared for a dividend cut, which is why Shell’s Class B shares of American Depositary Receipts started at a low in 2016 while having a dividend yield of below 8%.

But rather than reducing its dividend payout, Shell’s management decided to curtail its capital projects and dispose uneconomic assets. In June, the company announced a capital plan through 2020, which calls for a further cut in capital expenditure and more asset sales.

The stock price of Shell is up 24% since the beginning of 2016. Among other factors, a significant increase in oil prices driven by unexpected disruption in oil supply and better-than-expected oil demand across the globe could have played a role as well.

Higher Debt and Capital Expenditure Cut

The debt increased at a significant pace after merger with BG Group. Shell used $10 billion of its cash and rest of the amount was financed through debt, to ensure successful and timely closing of the merger. The increased interest payments and debt are a burden for the company in a low oil price environment.

To minimize the impact of the acquisition worth $54 billion, the integrated oil and gas company may implement a massive asset disposal plan. Shell intends to raise approximately $30 billon through sales of assets by 2018. The company is under pressure to lower its debt, which has now increased to roughly $70 billion.

Oil prices have taken much longer to recover than it was earlier anticipated. Consequently, Shell’s asset divestiture plan is expected to face some delays, and may possibly go beyond 2018. According to terms of the deal, Shell assumed all the liabilities of BG Group, which has further levered its balance sheet. Now, it plans to dispose of a major chunk of its portfolio to de-lever its statement.

The acquisition led to a major shift in Shell’s financial metrics. By the end of first quarter of 2016, bad debt represented around 26.1% of the company’s total capital, and has increased from 12.4% from last year same quarter. Shell executives made it clear that reduction in the debt pile of the combined entity is its number one priority. The oil major has also announced to reduce its headcount by 2,200 people to counterbalance the impact of the acquisition. After the announcement, total tally of the layoff this year moved up to 5,000 globally.

Shell also projects merger-driven cost savings of around $4.5 billion by 2018, up from $3.5 billion from its prior forecast. It also expects to reduce exploration expenses by 2018. Latest developments suggest that Shell’s capital investment is expected to clock in at $25 billion to $30 billion from 2017 till 2020. These figures are for the two companies combined, and represent a cut of 36% from 2014 levels.

In 2015, the company reduced its capital expenditure to less than $30 billion and paid dividend in the form of shares worth $2.6 billon, under a voluntary program. It also sold assets worth $5.5 billion, which resulted in a steep decline in return on capital employed from 7.1% to 1.9%.

Upcoming Debt Payments

The debt has rose for the oil major as it is bound to make bond principle payments for the next several years, with the significant payments expected to end by 2046. In the near term, it needs to make bond principle payments of $7.8 billion, along with interest payments of $2.79 billion in 2016 and 2017.

What could Go Wrong?

Oil prices can remain weak for years, with major repercussion for oil companies across the world. According to Shell’s projection, oil price would rebound to $60 per barrel by 2018 driven by reduced oil production, which is in line with analyst expectations. However, if oil prices fail to recover to a substantial level, Royal Dutch Shell may fall short of its free cash flow target. It may even have to speed up its asset divestment plant with larger proceeds expectations. The management opines that the new cost structure will generate enough free cash flow to cover the upcoming dividend payments, even if oil prices remain low for longer.

Moreover, analysts across the Street believe that Shell CEO Ben van Beurden has plans to generate $20–25 billion in free cash flow from 2019 to 2021. To fulfill its capital expenditure needs, the company would turn its average return on capital employed to 10%.

Conclusion

It goes without saying that debt reduction depends on massive asset sales as the total debt figure is gigantic. Asset disposal has gained traction among investors, which helps the company to lower its debt pile.

But everything comes at a price. There is also the risk that the company may fail to get the right price for assets it has prepared to sell out. This would prompt the company to delay its disposal plan rather than getting a lesser value.

Shell can put a cap on its capital investment to $25 billon instead of $30 billion, and fund its share buyback from the amount saved. But it would forgo its incremental future cash flow, which could be triggered through capital investment. Without a further, substantial recovery in oil prices, Shell will struggle to keep a balance between its near term promises and long-term prospects.

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