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Shell with a full tank of debt

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By JACK HOUGH: JULY 16, 2016

A dash of desperation is working wonders for module article chiclet Royal Dutch Shell. The price of Brent crude oil has fallen by half in two years, pulling Shell’s cash flow from operations well below what it typically needs to pay its dividend and fund exploration. Meanwhile, the purchase of United Kingdom gas specialist BG Group, completed in February, left Shell with a full tank of debt.

Something had to give. Investors braced for a dividend cut, which is why the American depositary receipts (ticker: RDS.B) started the year priced low enough to yield 8%. But rather than reduce its payout, Shell slashed spending on projects and sold low-return businesses. Last month, it announced a capital plan through 2020 that calls for more asset sales and a limit on capital spending.

The upshot for investors is that if van Beurden’s plan works, he predicts that by 2019 to 2021 Shell can generate average free cash flow of $20 billion to $25 billion a year—not counting divestments—after meeting its capex needs, while turning in a 10% average return on capital employed. That compares with organic free cash flow of just $5 billion a year on average over the past three years. The midpoint of van Beurden’s outlook, $22.5 billion a year, would give Shell a free cash yield of 10% based on its recent stock market value. It would provide more than enough money to quickly bring down debt and keep dividends coming, as well as share buybacks.

What could go wrong? Oil prices could remain weak for years. Shell’s plan assumes $60 oil by 2018, in line with the view of many analysts, based on production declines. The U.S. Department of Energy reckons U.S. oil production, 9.4 million barrels per day last year, will fall to 8.6 million this year and 8.2 million next year. China, too, recently cut its oil output sharply. If oil prices fail to rise, however, Shell could fall short of its free-cash-flow target, or have to settle for lower prices than it expects for its divestments. Management says the company’s back isn’t up against the wall on sales, and that the new cost structure is designed to generate enough free cash to cover the dividend even at the low point of the oil price cycle. But it could be wrong.

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