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A Frank Discussion On Royal Dutch Shell’s Dividend

Screen Shot 2015-04-09 at article published 13 April 2015

A Frank Discussion On Royal Dutch Shell’s Dividend


  • Before the BG acquisition, Royal Dutch Shell had a dividend payout ratio of 90% for 2015.
  • The acquisition of BG Group will put Shell on the hook for $15 billion in annual dividends as BG shareholders will own 19% of the company.
  • Royal Dutch Shell has built up a large cash position and indicated a desire to maintain the current dividend for the rest of 2015, making no dividend promises thereafter.

Before Shell (NYSE:RDS.B) announced an intention to purchase BG Group (OTCQX:BRGYY), the downtick in oil prices had created a very thin gap between the company’s dividend payout obligations and annual profits. Shell is on the hook for paying $11.8 billion in annual dividends to shareholders. For most of the past five years, this high dividend payout wasn’t an issue — Shell made well over $20 billion in profits annually between 2010 and 2012, so the current payout wouldn’t have even consumed half of the profits.

But the past three years have seen a continued decrease in Shell’s annual profits: $16 billion in 2013, $15 billion in 2014, and $13 billion in 2015. This has tightened Shell’s margin for safety — the dividend now eats up over 90% of profits, giving the company only $1 billion in annual profits to deploy for future earnings per share growth based on current oil prices. Like many of its peers, Shell is planning $30 billion in asset sales to help support dividend coverage over the next few years.

This is fine and good for making dividend payments, as Shell’s cash position has ballooned from $9 billion last year to $21 billion. But it is a problem to sell off profitable parts of the business to fund a dividend because it means that the business will be weaker when oil prices recover (and the production capacity will be diminished).

You can already see the troublesome effects of asset sales in Shell’s poor reserve replacement rate, which currently sits at 47%. That’s not good news for shareholders — a replacement rate of 100% means that you are adding as much oil to reserves as you are producing for sale. Shell’s proven reserves have been knocked down to 6 billion barrels of oil. It produces around 500 million barrels per year, so it is down to about 12 years of oil reserves assuming normal production rates.

The acquisition of BG reverses the tide of Shell’s reserve replacement issues and will contribute significantly to profit growth that will help Shell maintain its dividend over the next decade and beyond. BG is a company that produces 600,000 barrels of oil equivalents per day, to make $6 billion in annual profits, and the company is sitting on 30 years of reserves when you combine the 3 billion barrels of proven reserves with the 3.5 billion barrels of likely reserves. All told, this is a company that can help Royal Dutch Shell increase its profits to around $19 billion per year, improving the dividend payout ratio from 90% to 63%.

However, some people may be wondering: If this deal is an improvement of Shell’s long-term dividend health, why has the price of the stock come down to $59 per share and how come some people are concerned about Shell’s dividend safety? First of all, this transaction will greatly increase Shell’s total debt level. As of now, it stands at $45 billion for a total debt to capital level of 18%. That’s going to change. Shell is going to carry around $75 billion or so in debt, creating a total debt to capital level in the 30% range.

This will change investors’ characterization of Shell’s debt going forward. Right now, Shell has a lower-than-expected debt level for a company with such strong cash flow levels operating in a capital-intensive industry. After this transaction, Shell’s balance sheet will more accurately be described as “moderately high” for an oil company. A credit downgrade will also be possible, increasing Shell’s borrowing costs and reducing the company’s flexibility in the event that the price of oil stays down to the $50 per barrel range (the merger deal is predicated on oil returning to $90 per barrel sooner rather than later, and extended prices in the $50s would make this acquisition look as bad as Exxon’s purchase of XTO energy over five years ago).

Furthermore, part of the issue is that Royal Dutch Shell is issuing some of its own stock, as this transaction will give current BG shareholders a 19% stake in Royal Dutch Shell after the transaction. Because of the expanded shareholder base, it will now cost Royal Dutch Shell $15 billion to keep the current $3.76 dividend constant (note: The American ADRs represent two shares of Shell so that London investors will be familiar with a $1.88 dividend payout while American investors will be familiar with a $3.76 annual payout because of the way the sponsoring banks chose to bundle the stock in July 2005).

To put this in the frankest terms possible: Investors are concerned that Royal Dutch Shell is now on the hook for paying $3 billion in additional dividends to simply maintain the current annual dividend, and oil at $50 per share knocks BG Group’s $6 billion in annual profits down to $2.5 billion in annual profits. In other words, Royal Dutch Shell could be a company with a 90% dividend payout ratio making an acquisition that will cause it to be on the hook for more immediate dividends than it will make in annual profits from the BG acquisition.

There is some good news for investors on this front: Shell has pledged to keep the dividend steady for the rest of the year, and has not cut the dividend payout under the current regime. However, it is important to keep in mind that dividends must ultimately be supported by profits, and Royal Dutch Shell was already sending $0.90 on every dollar made in profits to shareholders in the form of a dividend. Looking ahead, the BG acquisition could make this issue worse in the short term if oil prices stay low, and a dividend cut may become possible if the price of oil does not experience a significant rise to $70 or higher within the next three years.

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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