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Royal Dutch Shell: Huge Dividend And Long-Term Growth Ahead

 

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Wayne Duggan: 20 July 2016

A number of British stocks have been hit hard since the referendum vote to leave the EU, but Royal Dutch Shell (RDS.A, RDS.B) is not one of them. Shares are now up 0.3% since the Brexit vote after initially falling more than 8% during the knee-jerk market sell-off.

With the possibility that the Brexit could severely impact British GDP growth in coming years, RDS.B offers a unique opportunity to invest in a company within a sector that is in a global upswing, a company that has significant international exposure and a company that is committed to maintaining the single largest dividend payment in the MSCI World Index.

RDS.B is in a position to grow FCF by dialing back capex without posing a threat to production. Furthermore, the company’s stable 6.6% yield is increasingly attractive to investors faced with European interest rates dipping into negative territory and U.S. Treasury rates dipping to their lowest level in history.

RDS.B’s balance sheet is solid and it has no serious near-term liquidity risks.

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(Source: Shell)

What are the market’s concerns?

RDS.B stock remains down more than a third from its 2014 highs prior to the global oil market collapse, but it has bounced nearly 50% off of its January lows when oil dipped below $30/bbl. Clearly, many of the concerns the market had have eased in recent months, but it’s important to review them nonetheless.

First, one of RDS.B’s biggest selling points is its nearly 7% dividend yield. While the company hasn’t cut its dividend a single time in the past 70 years, there’s no question its balance sheet has been stretched incredibly thin during the oil downturn. The company compounded its budget woes with its $53 billion acquisition of BG group as well.

Skeptical investors have questioned the acquisition and worried that the company has painted itself into a corner where it will have to choose between cutting the dividend and cutting production. However, management is addressing those concerns by planning to sell $30 billion in assets by the end of 2018 while maintaining current production levels.

Shell and BG combined to generate -$4 billion in FCF in 2015, and the company is on the hook for $15 billion in dividend payments by the end of 2016. However, despite the company giving no indication that it plans on cutting its dividend, the market seems to be pricing in a significant reduction in RDS.B’s dividend based on the stocks’ yield prior to the downturn in the 4.75% to 5.5% range.

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It seems as if one of two phenomena is at play: either RDS.B will stray from its 70-year history of reliable dividend payments, or the stock is significantly under-valued.

I believe that RDS.B has a clear path to maintaining its dividend and increasing its FCF via BG synergies, capex reductions and asset sales. RDS.B has yet to turn the quarter in terms of FCF. But once it does, the stock will likely see significant upside as it returns to its historical yield range.

In 2015, RDS.B generated roughly $30 billion in OCF, including $10 billion in asset sales. With capex of $26 billion and dividend payments of $12 billion, RDS.B had to take on significant debt to make its dividend payments.

Management will continue to operate with the long-term goal of getting RDS.B’s payout ratio back down to its historical range between 50-100%. I believe it is on pace to get there by the end of 2017, even if oil prices remain as low as $45/bbl. Earlier this month, the US Energy Information Administration upped its 2017 price forecast for Brent crude from $49/bbl to $52/bbl.

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Capex cuts

The path to FCF recovery without a dividend cut for RDS.B involves significant capex reductions. Management has assured shareholders that it plans on disposing a total of $30 billion in assets by the end of 2018, which will provide plenty of funds to make its dividend payments. Obviously, it’s never good to dispose of assets to pay the bills, but it certainly beats not paying the bills. Still, RDS.B’s proved reserves have already decreased by 16% in the past two years.

RDS.B’s capex skyrocketed from $15 billion in 2004 to over $37 billion by 2014. In the company’s Q1 earnings report in May, CEO Ben van Beurden said that 2016 capex is “clearly trending toward $30 billion, compared to previous guidance of $33 billion,” which is a good sign of progress.

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I believe that RDS.B can further reduce capex to roughly $27 billion in 2017 while maintaining current production levels.

RDS.B’s total oil & gas production in 2015 was 1.114 billion boe. Following the BG acquisition and in a modestly- improving oil price environment, I believe that the company should be able to produce roughly 1.5 billion boe per year.

In order to achieve this level, the company will have expenses associated with development, exploration and downstream segments.

Development

In terms of development, the cost associated with adding a barrel to proved developed reserves has fallen more than 20% from 2014 peaks and will likely continue to fall to around $15/bbl.

In addition to deflation, increased budget scrutiny will eliminate much of the spending on fringe projects that has inflated development costs in recent years. Inefficient, high-risk and high-cost projects will be first on the chopping block, and the ones that remain will be only the lowest-cost projects with the highest potential.

Finally, there is a significant delay between the spending associated with projects and the classification of oil as “developed reserves.” During these times of aggressive development spending, development costs often appear much higher than they actually are. Fortunately for oil companies, the opposite is often true during times of conservative development spending.

From 2007 to 2010, unit development costs stayed in the $12/boe range, and it wouldn’t be surprising to see them return to this level during the current downturn. Historically, development costs have typically stayed relatively close to 20% of the price of Brent, implying a current cost of roughly $9/boe. However, if prices return to the $60/bbl range, a development cost of $12/boe would be in-line with the historical average.

At a cost of $12/boe and production of 1.5 boe, development capex should total around $18 billion.

Exploration

When it comes to exploration, RDS.B has been rather loose with the spending in recent years. While that is certainly not good news for investors, it also implies plenty of room for improvement.

From 2012 to 2015, RDS.B spent roughly $6.20/bbl in exploration costs, higher than any other oil major. Taking BG’s numbers into account, that cost falls to $5.90/bbl. RDS.B estimates that that number fell to $2/bbl in 2015, in-line with BP (NYSE:BP) and Exxon Mobil (NYSE: XOM).

Roughly 30% of exploration spending is unsuccessful and therefore is subtracted from OCF rather than totaled in capex. Therefore, exploration’s total contribution to 2017 capex should be approximately $2 billion.

Downstream

Finally, RDS.B’s capex related to downstream segments has been relatively stable at around $5 billion per year in recent years and will likely remain the same in the future.

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(Source: Shell)

Summing up the total projected capex of $18 billion from development, $2 billion from exploration and $5 billion from downstream segments, a total capex of $25 billion is certainly not out of the picture in 2017. That number would represent a $12 billion/year reduction (or 32%) reduction from 2014’s capex total and potentially a 33% increase in production from 2014’s total of 1.124 billion boe.

Will Oil Prices Limit Development Capex?

The major problem with forecasting $18 billion or more in annual development capex is that there are a limited number of development projects out there in the world that have a positive net present value (NPV) when oil prices are near $45/bbl. Rystad used bottom-up field-by-field analysis to forecast RDS.B’s development capex by splitting it into projects with breakeven prices of <=$40/bbl, $40-60/bbl, $60-80/bbl and >$80/bbl.

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According to Rystad, RDS.B’s development capex will fall to $16 billion in 2017. The Rystad projections highlight the importance for RDS.B of a long-term recovery in oil prices, as capex on projects with beak-even prices peaks below $60/bbl maxes out at just under $20 billion through 2025. Ultimately, Rystad sees total development capex surging to $40 billion per year by 2022. Obviously, with more than half that devoted to projects with a breakeven price above $60/bbl, Rystad is expecting a significant long-term price recovery for crude oil.

It seems unlikely that oil prices will significantly exceed $60/bbl prior to 2018, meaning that the number of attractive projects for RDS.B will be limited in the near-term.

Can RDS.B afford even $25 billion per year in capex?

At current oil prices, RDS.B will likely generate roughly $34 billion in operating cash flow in 2016. Following the BG acquisition, it will also owe $15 billion in dividends, leaving only $19 billion for capex.

In addition to cash flow, management is targeting $10 billion in asset sales this year. An additional $3 billion will likely come from shareholders opting to receive shares of stock rather than cash dividend payments.

On the surface, it would seem as if RDS.B will have approximately $32 billion in funds available to cover capex after the dividend is paid. That’s good news considering the company’s net debt has ballooned from $27 billion to $57 billion during the downturn. It’s safe to assume that any remaining funding outside of dividends and capex will go toward paying off debt. That total will likely amount to no more than $5-6 billion per year for the foreseeable future, but paying off debt would be a welcome contrast to piling it on, which has been the approach in recent years.

How does RDS.B’s upstream spend compare to peers?

Morgan Stanley subtracted out downstream capex estimates and used the forward guidance provided by other oil majors to estimate upstream capex/bbl for RDS.B’s competitors. A capex of $26 billion for Shell would place its upstream capex/bbl of around $14. That falls just below the average Morgan Stanley estimates for the other oil majors of $16/boe. Estimates range from $11/bbl for Exxon to as high as $20/bbl for BP.

Cost Savings

Following the addition of BG Group, RDS.B management announced they expect about $2 billion per year in cost synergies from the merger. In addition, in its annual report, RDS.B projected $3 billion in total cost savings in 2017.

On top of BG synergies and internal cost-cutting initiatives, supply chain costs will likely remain pressured in coming years as well.

It’s very difficult to quantify the actual synergies that RDS.B and BG will realize, so investors mostly have to take management’s word on the $2 billion annual estimate.

However, looking strictly at Shell’s past operations prior to the BG acquisition, there are plenty of opportunities to cut costs.

From 2011 to 2014, RDS.B’s production increased 37% annually while its major peers upped production by an average of just 24% annually. In fact, Shell’s production growth was the highest of all majors during that time period.

At the same time, RDS.B trimmed just 11% of production costs in 2015, the lowest cost-cutting in the entire group and well short of the average 20% reduction.

Taking both production and cost-cutting into account, RDS.B’s production cost per barrel in 2015 came in 22% higher than it was in 2011. The rest of the oil majors’ production costs ranges from 25% below 2011 to 12% above.

With production costs still falling, it’s safe to assume that the oil majors will likely all reach their 2011 cost level in 2016 or 2017, meaning RDS.B can trim 22% off of its 2015 costs. Since 2015 production costs totaled about $13 billion, that means that the company should be able to trim nearly $3 billion in costs, likely by 2016. When BG cost-cutting is factored in, the number might approach the $5 billion level.

Another major cost-cutting avenue has been payroll. Back in 2001, Shell and BP both produced between 70 and 80 kboe per employee per year. By 2014, that efficiency had declined to 27 kboe/employee for RDS.B and 28 kboe/employee for BP.

In 2015, however, BP upped its production per employee by 19% to 34 kboe. Total SA (NYSE: TOT) and Statoil ASA (NYSE: STO) also saw meaningful improvements. RDS.B, on the other hand, saw its production per employee fall further to 25 kboe/employee.

Assuming that RDS.B could re-gain the same level of production per employee that BP has, the company could cut 9,000 of its 35,000 2015 employees. In May, the company announced another 2,200 layoffs on top of the 7,500 layoffs it issued in 2015 and the 2,800 jobs that will be cut related to the BG Group acquisition.

Since RDS.B’s cost per employee has only risen about 1.3% per year since 2001, its employee costs are almost exclusively tied to the number of workers the company employs.

In 2015, RDS.B logged roughly a $500,000 production cost per employee. That means that the most recent round of 2,200 layoffs will save RDS.B about $1.1 billion. However, if Shell could ultimately cut 9,000 upstream workers, cost savings could approach $4.5 billion.

It’s likely that, in addition to the $2 billion in synergies, significant cost-cutting opportunities exist within BG Group as well.

The $30 billion asset disposal plan

RDS.B’s turnaround plan sounds all well and good, but one of the pan’s key components is a massive $30 billion assumption. Will it really be that easy for RDS.B to dispose of $30 billion in assets in the middle of the worst oil market slump in recent memory?

The idea that RDS.B’s stock is solid investment, that its dividend is safe and that it will be able to pay off its massive debt while maintaining decent credit is all based on the idea that it can raise money by selling a huge amount of assets into a buyer’s market.

RDS.B management hasn’t shed much light on exactly which assets it intends to unload, but there are a number of assets on the company’s balance sheet that would seem to be appealing to buyers. While finding buyers might be challenging, RDS.B appears to have more than enough quality assets to raise $30 billion.

Upstream assets

In terms of upstream assets, Morgan Stanley notes that Shell has up to $17 billion in smaller field properties that could likely be operated more efficiently by smaller companies.

In addition, RDS.B operates in 38 major global basins, more than both Exxon and Chevron Corporation (NYSE: CVX). RDS.B currently has up to $8.5 billion in assets in countries with modest growth potential but meaningful value for a buyer. The Canadian oil sands operation is a perfect example. RDS.B’s Canadian oil sands assets are valued at up to $3.5 billion depending on the price of crude. Canadian oil sands have both a high break-even price and high CO2 emissions.

Wood Mackenzie even speculated that RDS.B could package its Kashagan properties with BG’s Karachaganak projects and dispose of those assets for $5.0-8.5 billion.

RDS.B also has a modest listed stake in Woodside which is likely valued at $3-4 billion.

Mistream & downstream assets

Finally, RDS.B has up to $35 billion in midstream and downstream assets, including interest in 23 refineries, 25 chemical facilities, 8 base oil manufacturing plants and 43,000 Shell-oil branded filling stations worldwide. Theoretically, some or all of these assets could be “dropped down” into RDS.B’s Shell Midstream Partners LP (NYSE: SHLX), but management has previously said that the MLP’s annual capacity for asset acquisition is only $1-1.5 billion. Still, that means that the MLP could account for up to $4.5 billion in asset disposals from 2016-2018.

All together, these non-core assets provide a total value starting at around $35 billion on the extreme low end and could be valued at twice that in the case of significantly higher oil prices in coming months.

The other part of the asset disposal equation is the market itself. It doesn’t matter how much RDS.B’s assets are worth if there are no buyers. But despite the tightening of the oil market, there were still about $150 billion in oil asset deals in 2015. Projecting that market forward for the duration of RDS.B’s asset disposal program, RDS.B is looking for only $30 billion out of more than $450 billion in likely deals through 2018. Shell’s $30 billion represents only about 7.5% market share, which seems like a reasonable goal.

Production and cash flow growth

While RDS.B is now scrambling to cut capex by as much as possible, the company will still enjoy the fruits of its recent aggressive spending in the next several years. By the end of 2018, RDS.B expects projects like Gorgon LNG, Prelude FLNG, Stones and Clair will be up and running, providing a major shot in the arm to production and cash flow. Kasagan is also expected to be up and running again in 2017. BG also has major start-ups in the works in Brazil.

Despite major cost-cutting initiatives, RDS.B could easily grow production by 8% in 2017.

Using extremely conservative crude oil price assumptions of $38/bbl in 2016 up to only $46/bbl in 2018, Wood Mackenzie still projects that Shell’s oil & gas fields portfolio could generate 36% cash flow growth from 2016 to 2018 (excluding exploration costs and overheads).

This type of growth would be on-par with projections from Total, Statoil and Exxon and well ahead of BP.

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(Source: Shell)

Potential LNG Headwinds

The LNG market is on the precipice of a major production boom resulting from a global investment frenzy from 2011 to 2015. Twenty-four new LNG projects are expected to come online between 2015 and 2018 that are expected to account for roughly 30% of global production.

Here’s how Morgan Stanley describes the LNG market issues RDS.B faces:

Much of this LNG has been sold forward by the major operators at oil-indexed prices, but not all, leaving companies to sell those cargoes on the shorter-term ‘spot’ market. Also, some of their customers have over-contracted. Although they are fulfilling their contractual obligations to take these cargoes, they are re-exporting those cargoes onto the spot market as well. All of this makes for an oversupplied LNG market.

For RDS.B, that means major potential earnings pressures on the company’s Integrated Gas segment. However, the segment is a relatively small part of the RDS.B picture. Last year, RDS.B management reported that it sold only about 15% of its LNG on the spot market as of 2014. Roughly 65% of it was sold under long-term contracts linked to oil prices and a fourth of it was sold at hub prices.

RDS.B and BG’s combined LNG portfolio accounted for roughly 48 mpta of LNG in 2015, a number that could grow to above 60 mpta by 2020. While that amount of capacity in an oversupplied market may seem troubling, it’s important to remember that LNG prices have remained closely correlated to crude oil prices in recent years. In fact, LNG spot prices have traded between 10 and 20 percent of the price of Brent crude throughout the entire downturn. In other words, if this relationship remains intact, LNG prices should recover along with crude oil prices in coming years.

Brexit Impact

Of course no discussion about British stocks these days would be complete without a mention of the impact that the Brexit vote will have on the future. Unfortunately for RDS.B, the company is far from immune to the economic impact of the Brexit.

CEO Ben van Beurden has said that the Brexit could slow the pace of RDS.B’s $30 billion asset sale initiative, particularly in the North Sea. Shell has commissioned Bank of America to find buyers for several of the company’s North Sea assets, including Shell’s estimated $2 billion stake in the Buzzard oilfield. The company is also reportedly offering a package that includes Shell’s stake in the Schiehallion oilfield, assets in the Nelson, Armada, Everest, Lomond and J Block fields and its stake in the Bressay development.

The CEO’s comments suggested that it may take more than three years to hit the $30 billion asset sale goal, but a company spokesperson followed up by saying “there has been no change to the previous statements we made on the three-year, $30 billion divestment program.”

Stock Outlook

Shell’s stock is up 0.3% since the Brexit vote and is now up 23.9% in 2016. While it wouldn’t be surprising to see the stock take a breather after its large run-up, the company seems well-positioned to cut costs, improve cash flow, pay its world-class dividend and pay down its debt.

The Brexit offers uncertainty in terms of free European trade, but Shell’s international revenue diversity means that headwinds to the U.K. economy won’t impact the company as much as other U.K. companies. Until RDS.B begins delivering consistent, predictable free cash flow growth, the stock’s upside will likely be limited in the near-term after its strong 2016 performance. However, management seems to have the company well-positioned for the long-term recovery in the global oil market.

The aggressive acquisition of BG Group may have made many investors nervous about Shell’s ability to maintain its dividend and a respectable credit rating. But now that the oil market has shown some signs of stability, the huge acquisition has set the table for long-term growth opportunities ahead.

RDS.B is set to release Q2 earnings on Thursday, July 28. Aside from consensus Q2 EPS and revenue estimates of $0.49 and $55.5 billion, respectively, investors should be watching for any potential improvements in cash flow, any commentary on capex or asset sales, and any changes to debt levels.

Assuming management can continue to execute its plan and that the oil market maintains a slow and steady long-term recovery, RDS.B certainly has the potential for years of solid growth ahead and will continue to sport one of the best dividends in the investment world.

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.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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