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Royal Dutch Shell – Income Investors Should Look Elsewhere

Casey Hoerth: Dec. 14, 2016 11:09 AM ET

Summary

Shell plans on between $25 billion and $30 billion in capex next year, with flexibility to the downside.

I do not expect Shell to achieve cash flow balance in 2016, even with asset sales.

I continue to recommend other energy companies over Royal Dutch Shell, until either oil prices recover more or until Shell does something else to achieve balance.

Over the course of 2016 I haven’t recommended much when it comes buying to upstream or integrated oil companies. The reason was that I felt many still weren’t doing enough to balance their money coming in versus money going out. The CEO of one of my favorite companies, in their latest analyst day, recently quipped that energy companies couldn’t afford to wait to be ‘bailed out’ by higher oil prices.

I agree with that sentiment, and I have used it as something of a litmus test for 2017. Throughout 2016 I’ve been cautious on Royal Dutch Shell (NYSE:RDS.A) for this reason. After the presidential election I’ve been admittedly trying to catch up with analyst meetings across the energy industry, and so today I will look at Shell’s plans for 2017 through the lens of my ‘cash flow litmus test.’

Re-shuffling the deck

Back in 2015 Shell acquired integrated gas giant BG Group. This gave Shell a brand new book of LNG-centered capital projects and an opportunity by which to ‘high grade’ its portfolio. Since buying BG Group, Shell has worked to integrate BG Group’s high-quality assets, and at the same time trim some of its legacy assets which no longer are a strategic fit for the company or which offer lower returns.

Looking at Shell’s capital projects for 2017, we can see the ongoing fruits of this policy. Let’s take a look at this from the bottom-up.

This page may look a bit ‘busy,’ but you can see that, for the next three years, Shell plans on divesting $30 billion worth of assets. In short, this divestiture will help Shell pay for a good chunk of its capex and/or dividends in the likely case that cash flow falls short in the subsequent years.

Notice that Shell only has $5 billion in divestitures lined up so far, when they were expected to do $10 billion earch year, so right now they’re a good ways behind schedule. As management said, this divestment campaign is value-driven and not time-driven.

As for where capital is going, Shell will be putting a big growth emphasis on deepwater. Admittedly, I’m a bit surprised, as I thought the growth emphasis would be in LNG projects, but it seems that Shell has instead opted to keep LNG as a ‘cash flow engine,’ probably via realizing synergies from the BG Group assets.

The chart above shows that the company intends to more than double its offshore production between 2015 and 2020. This is a large, long task that will cost a lot. Much of this growth will be from discoveries in the Brazilian ‘pre salt’ fields and the Gulf of Mexico. Management stated that breakevens for its Brazil and Gulf of Mexico assets to be in the high $40 range.

The big question is, of course, whether this plan can achieve cash flow neutrality. Let’s have a look at Shell’s capital expenditure plans, with the understanding that the plan is “flexible” and that management can further decrease that budget if need be.

So, in 2017 the company expects to spend ‘around’ $25 billion on base projects plus growth. Also, each year the company pays out around $9 billion in dividends, so that’s a total obligation of $34 billion.

Will Shell generate enough cash flow to cover that? Frankly, I don’t believe so. For example, over the last 12 months the company has generated only $16.8 billion. While higher crude prices are looking increasingly likely, it would take quite a recovery for Shell to achieve cash flow neutrality. The remaining gap was supposed to be plugged by non-strategic asset sales, but, as I mentioned, it looks as if those are going a bit slower than expected.

With all that in mind, I’m going to do a ‘back of the envelope’ calculation and be generous to Shell while doing so. First, let’s assume cash flow generated jumps up to $20 billion, then let’s assume Shell achieves $8 billion in divestitures (which would be $3 billion more than what it lined up last year). That brings us up to $28 billion; about $6 billion short of expectations.

That gap would likely have to be plugged from cash or additional debt. The company’s debt rating from Moody’s is an Aa2, and while it is not on any watch list for a down grade, the general outlook is ‘negative.’ The company’s credit rating is secure at the moment, and may very well continue to be throughout the year, but there is a possibility that the situation could become tenuous if Shell needs to tap debt markets once again to plug its cash flow gap.

To sum up, I don’t believe that investors should be tempted by Shell’s 6.92% dividend. While I don’t think that dividend is in immediate danger, the company won’t be doing itself a favor by continuing to take out debt to plug its cash flow gap. In many ways, a lowered credit rating could be even worse than a slashed dividend, and so I continue to recommend income investors look elsewhere, despite that tempting yield. The best thing to do regarding energy companies in 2017 is find the ones that intend to more-or-less balance out their cash flow in the coming year. This is year three of sub $60-crude prices, and I think most companies should have adapted by now.

As for companies that have managed some kind of cash flow balance, I continue to like companies such as Exxon Mobil (NYSE:XOM), ConocoPhillips (NYSE:COP) and EOG Resources (NYSE:EOG), each for a different reason. If you’re interested in Shell, feel free to follow me here on Seeking Alpha. I will continue to provide update articles on this company when doing so is material and relevant.

Disclosure: I am/we are long XOM.

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.

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