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Royal Dutch Shell Is Now A 7.54% Dividend Yield Monster

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Screen Shot 2015-08-13 at 11.35.25Aug. 24, 2015 6:45 PM ET

Summary

  • Stock market downturn takes Shell’s dividend yield to an astonishing 7.54%.
  • The dividend looks reasonably safe.
  • High initial yield but little growth expected in coming years.

Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) doesn’t need an introduction. This Anglo-Dutch multinational is one of the largest, integrated oil & gas majors in the world. Its share price has dropped nearly a quarter since the start of the year, pushing its dividend yield ever higher. While commonly regarded by many DGI investors as lesser quality than Exxon Mobil (NYSE:XOM), I believe the current market situation highly favors including this stock in the energy component of your dividend portfolio.

With a dividend of $0.47 per quarter per ordinary share, or $0.94 per ADR, Shell now trades at an astonishing dividend yield of 7.54%! In the current zero interest-rate environment, it is hard to fathom you’re getting such a monster yield from world’s third-largest business — last year, Royal Dutch Shell had a revenue of $431 billion.

Why it yields 7.54%

There are several reasons of course why Shell’s dividend yield keeps creeping higher, and unfortunately it’s not good news. The most important reason is of course the dramatic collapse of the oil market, which is hurting profitability. Little over a year ago, oil traded near $110 and now crude is hitting the $40 mark, something few people foresaw last summer.

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Source: Finviz

The oil and gas sector as a whole has been beaten down as the price of oil keeps dropping. In the first half of this year, Shell posted earnings per ADR, excluding one-time items, of $2.24, down from $4.26 in the first half of 2014. Since the start of 2015, RDS.B shares have plunged from $69.56 to $52.53 and shares are now trading at a level not seen since 2010.

The share market didn’t react favorably to Shell’s plan to acquire BG Group (OTCQX:BRGYY) for $70 billion either. The deal will lead to dilution due to the issuance of new shares, and analysts fear Shell may have overpaid for the acquisition as the company is offering a 50 percent premium for BG. After the deal is completed, Shell plans to increase asset sales, resulting in divestment of roughly $30 billion in assets in the 2016-2018 timeframe. Shell got lucky in selling some of its assets before the price of oil collapsed, but I’m a bit concerned if the company is going to be able to get a good price for these assets if the oil downturn prolongs into 2016-2018.

The BG Group deal is part of Shell’s vision to become a leading player in the natural gas market. Shell began producing more gas than oil in 2013 and the company’s long-term vision is that demand for gas will increase 60 percent by 2030 from its 2010 level. In the electricity market, gas plants may see a significant uptick; switching to gas can dramatically cut CO2 emissions versus coal plants and leads to less air pollution. The combined company will be world’s largest liquefied natural gas (LNG) producer and also advances Shell’s position in the deep water oil segment.

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Source: Royal Dutch Shell

A third but smaller factor is that Shell is challenging public opinion by going ahead with its controversial drilling plan in the Chukchi Sea, a remote part of the Arctic. This sparked the fury of environmentalists who fear Arctic off-shore drilling could result in a major spill that would be very hard to contain. Shell hopes its drilling will confirm the existence of huge oil reserves in the region, but not everyone is convinced the reward is worth the risk. Dutch pension manager ABP, holder of about 0.5 percent of Royal Dutch Shell’s shares, is one of the more outspoken opponents. They would rather see Shell focus on less risky projects.

Unlike BP’s (NYSE:BP) Deepwater Horizon, drilling in the Chukchi Sea would be in shallower water of 150 feet deep, instead of the 5,000 feet in the Gulf of Mexico. The big problem, however, is that the Chukchi Sea is extremely remote, making the logistics a nightmare. The nearby coastal region has no real road system, lacks deepwater ports and can only be reached by boat in summer.

The closest Coast Guard station with equipment for responding to a potential spill is in Kodiak, Alaska, more than 1,000 miles away. Furthermore, while oil in warm waters is subject to microbial degradation, this is not the case in the Arctic’s freezing water, which means the long-term effects could be much worse than BP’s Deepwater horizon disaster.

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Source: Royal Dutch Shell

Not that Shell is the only oil firm interested in drilling there, but the other majors put their plans for Arctic drilling on ice for now. Despite earlier misadventures in 2012 in the region, Shell thinks it can get the job done safely and is proceeding with the project.

One of the prime reasons the company is going ahead with unpopular projects like the Chukchi Sea is perhaps Shell’s poor reserve replacement rate. Prior to the deal with BG Group, Shell’s replacement rate was only 47 percent, which means the company is draining its reserves, and Shell argues the Arctic is just too big a prize to miss out on.

The Chukchi Sea project is really a very long-term project, though. Even if the company finds a significant oil reserve there, production isn’t anticipated to start until 2030. In an interview with Bloomberg, Ann Pickard, Shell’s top executive for the Arctic, said Chukchi oil would be competitive at oil prices of $70 a barrel in 2030 and a “smashing success” at $110.

Dividend policy

Royal Dutch Shell is often regarded as one of the biggest widows-and-orphans stock in Europe because it takes dividends very seriously. In an interview with Bloomberg, CEO Ben van Beurden called Shell’s dividend an iconic item and he pledged he would to everything to protect it. Shell has not cut its dividend since 1943; it is a very shareholder-friendly company and you can be reassured that a dividend cut is the last thing on management’s mind. Van Beurden claims the priority regarding the use of cash at Shell is debt service first, then dividends and then a balance between buybacks and capital investment.

Royal Dutch Shell shares have two classes: A and B. The share classes are not the focus of this article, so I’ll make this quick. The A shares are subject to Dutch law and have a 15 percent dividend withholding tax, whereas the B shares fall under UK law and have no dividend withholding tax. Sometimes buying RDS.A can make sense if you can reclaim the foreign taxes paid, but at present RDS.B clearly seems to be the desirable class for new investors as the discount of the A versus the B shares has shrunk to a mere 2 cents. Sometimes the discount can be several dollars per share, so it’s worth to pay attention to this.

In many ways owning RDS.B is like owning shares of a US-based company. Royal Dutch Shell reports its financial results in US dollars, it has a quarterly dividend payout schedule, and since 2007, it even declares its dividends in US dollars so currency fluctuations will not hurt the dividend income of US investors. Since the company started declaring dividends in US dollars, its dividend has increased from $2.88 in 2007 to $3.76 in 2014. This represents a seven-year dividend growth rate of 3.88 percent.

In the short term, dividend growth looks uncertain. Royal Dutch Shell promised to pay the same $3.76 dividend per ADR in 2015 and at least that amount in 2016. Beyond that, future dividend growth is going to depend a lot on future oil pricing.

At the moment, Shell offers a scrip dividend option, but there are some important drawbacks to consider, and some investors are a bit annoyed by the on-and-off nature of Shell’s scrip dividend. The scrip dividend was cancelled in 2014, but reinstated in April after the announcement of the BG Group acquisition. The goal of the scrip dividend is to conserve cash amid the downturn in the oil market.

If all goes as planned, the scrip dividend will be withdrawn again in 2017 as Shell plans to commence a $25 billion share buyback to offset some of the dilution from the scrip dividend and the BG Group deal. If you have RDS.A shares, there is no withholding tax on the scrip dividend as the Netherlands does not tax scrip dividends. To further complicate things, if you have RDS.B shares, you must be careful with the scrip dividend as Shell exclusively issues RDS.A shares under this program.

Over the next four quarters, Shell ADR shares are expected to pay $3.76 in dividends. This resulted in a dividend yield of 7.16% at Friday’s closing price, far above the average yield offered in recent years, and Monday’s drop increased the yield to a stunning 7.54%.

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Source: YCharts

Outlook

While oil majors like Shell are well-positioned to handle downturns like these, an investment in this company requires the belief that oil pricing will eventually return to a much higher level than today. When Shell announced its plan to acquire BG Group in April, the company said the financials only really work with an oil price of $90 a barrel in 2018, more than twice the current price of oil. This may have been a worst-case scenario, though. Last month Shell CFO Simon Henry insisted over a lunch with investors and analysts that the deal works at $70 a barrel and would add immediately to cash flow as there are much greater, but harder to verify, synergies than what was previously announced.

Last month Shell announced it’s responding to the low oil price environment with 6,500 job cuts and a further capital investment reduction of $7 billion. These are challenging times and Shell is preparing for a prolonged downturn.

At the end of the second quarter Shell’s gearing, which measures the extent to which a company’s operations are funded by debt, was 12.7 percent. This compares to a gearing of 18.8 percent for BP, 19.58 percent for ExxonMobil, 20.63 percent for Chevron (NYSE:CVX) and 25.9 percent for Total (NYSE:TOT).

Once the BG Group deal is complete, Shell’s gearing is expected to increase to just over 20 percent, which still gives the company plenty of wiggle room to temporarily finance the dividend via debt in case the oil downturn lasts longer than anticipated.

However, the big increase in debt is one of the reasons why S&P downgraded the rating on the oil major’s long-term debt from AA to AA- last month. S&P believes the soft oil pricing and continued high level of capital expenditures are weakening Shell’s financial risk profile. On the other hand, Shell vows to pay down debt from 2016 to maintain a strong balance sheet and has a self-imposed gearing ceiling of 30 percent.

Based on adjusted quarterly earnings of $1.22 per ADR from Shell’s Q2 2015 earnings report, the company currently trades at a P/E of 10.76 and has a dividend payout ratio of 77%. These numbers are of little meaning though as oil keeps plunging lower, which will almost certainly result in lower earnings in the third quarter. On a cash flow basis, Shell is bleeding billions a year at current capital expenditures, as calculated over here, but it can take advantage of the current low-interest rate environment to finance the dividend for several years before running into significant trouble.

Conclusion

I believe an oil major like Shell is very resilient. I have no crystal ball to predict where oil is going, but if you’re looking for an income-producing stock and can forgive a couple of years with no or little dividend growth, Shell deserves a place in your portfolio.

There are definitely worse places to put your money than one of world’s largest corporations offering a dividend yield in excess of 7 percent. The dividend looks reasonably safe and could survive a multi-year oil downturn — at the cost of more debt on Shell’s balance sheet.

At the current yield, it takes a mere 10 years to get your initial investment back via dividends, and once you figure in dividend reinvestment, an investment in Shell can produce spectacular results over the long run once the oil market recovers.

Disclosure: I am/we are long RDS.B. 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.

SOURCE

royaldutchshellplc.com and its sister websites royaldutchshellgroup.com, shellenergy.website, shellnazihistory.com, royaldutchshell.website, johndonovan.website, shellnews.net and shell2004.com are all owned by John Donovan. There is also a Wikipedia article.

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