The Times: BP and Shell secure tomorrow’s dividends

The Times: Money
February 11, 2006
WITHIN a few days of each other, BP and the newly merged Royal Dutch Shell reported the biggest and second-biggest profits ever recorded by British companies. Only the order of precedence brought surprise.
When Shell came up with $22.9 billion (£13billion), analysts assumed that its record would be short-lived. This was, after all, a company that had automatically been tagged as “troubled” ever since the previous board’s lax definitions of proven oil and gas reserves had come to light.
In the event, BP came up a few hundred million of profit short. Its shares were caned even more severely than Shell’s had been, when the Anglo-Dutch group’s profits were compared unfavourably with the American Exxon Mobil.
These short-lived bouts of selling reflected profit-taking as much as disappointment. On either count, there was little to complain about, apart from fear of political assaults.
Both companies have performed roughly in line with the all-share index over the past year. Most of their outstanding performance came in 2004. Fourth-quarter profits may have suffered from sharp fluctuations in oil prices during the autumn, but BP’s one-off costs, mainly for accidents and disruptions at its North American refineries, should not damage future earnings.
Either way, investors are cautiously sceptical about the supposed new era of expensive oil, noting that prices have been cyclical ever since Opec was formed. Both BP and Shell shares now trade at less than ten times likely 2006 earnings per share, below the market average. New paradigms tend to prove far from permanent.
Up to a quarter of the oil multinationals’ 2005 profits and most of the growth were accounted for by high and rising oil prices. Brent crude peaked at $67 a barrel in August, fell to $53, and then scrambled back above $60.
Unless oil prices fall dramatically, integrated groups such as BP and Shell will benefit in the first half of the year of higher year-on-year oil prices. But it will become harder to sustain progress later. The ratings allow fully for that.
These are also companies that, by being integrated from geological research to garage forecourts, can make decent profits and pay decent dividends no matter what happens to oil prices. Shell, which has traditionally been stronger in marketing than oil production, is naturally the steadier of the two but, under Lord Browne of Madingley, BP has taken strides in marketing its brand globally as well as strengthening reserves and finding as much oil as it sells.
Like top banks, BP and Shell both have great consumer and business franchises as well as the resources to mend any weaknesses in their armoury. Their top priorities are to sustain these franchises and avoid terrible decisions.
In the latest McKinsey on Finance quarterly, the consultants argue that the greatest risk facing the top five companies is of spending too much of their estimated £70 billion of 2005 cashflow on projects that are only viable if oil prices stay high. Lord Browne clearly agrees. For instance, he ruled out bidding for the Spanish Repsol.
BP claims to have stakes in more oil developments than its rivals but is also pledging enormous share buybacks, bigger if oil prices stay high.
In this case, buybacks are justified because short-term growth expectations are low and reductions in capital will help to sustain dividend increases (10 per cent for 2005).
On top of its peculiar embarrassment over its reserves, Shell is still replacing only three quarters of the oil and gas it is using.
It will give higher priority to exploration and development, but not on markedly more extravagant assumptions about future oil prices.
With luck, Shell and BP will not jump too deeply into high-cost alternative energy, as McKinsey suggests, because that would gear profits more highly to oil and gas prices. Experience tells them to stick to oil and gas. That is what has made their dividend yields, which are above 3 per cent, among the safest and the most likely to outpace inflation.

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