Royal Dutch Shell: Don’t Miss This Stock
Royal Dutch Shell (RDS-A) (RDS-B) announced its first quarter 2016 results on 4th May. During the quarter, the company completed the acquisition of BG Group on 15th Feb at a final transaction price of $ 54 million or £ 37 billion. So the results for the first quarter include the one and a half months performance of BG Group too.
After adjusting for the identified items, Shell’s earnings on the current cost of supplies (CCS) basis were $ 1.6 billion compared with $ 3.7 billion for the first quarter 2015, a decrease of 58 %. And the CCS based EPS was down 63 % to 22 cents per share.
Shell is much more into upstream business than it is into downstream. So obviously, the impact of oil, gas and LNG prices on the company’s earnings was also much greater than that on those companies that have a more balanced business portfolio. Further, the significantly lower refining margins driven by oversupply, higher inventory and a relatively mild winter in the US and in Northern Europe also affected the downstream business negatively.
The oil and gas prices had been at their lowest in many years in the quarter under consideration here. Brent oil prices were some 37 % lower than year-ago levels; similar declines in WTI and the other crude markets. The realized gas prices were some 36 % lower than one year ago with a strong decline in gas prices seen in all the markets. But that time is hopefully behind us now and the fundamentals now look a lot better. Oil has come up from below $ 30 to around $ 45 a barrel. But Shell still needs oil prices to trade somewhere around $ 70 per barrel in order to make cash at the rate that it is spending at the moment.
The company continued to reduce the capital spending and operating costs. The capital expenditure guidance has been thus revised from $ 33 billion to $ 30 billion for the full year 2016. And this could further be reduced possibly as a result of increased capital efficiencies and savings from projects after the BG acquisition. In fact, the figure of $ 33 billion was announced only around the start of this year. However, if we use the combined capital spending of 2014 i.e. $ 47 billion for comparison, the new guidance is 35 % below that level. And that’s exactly what you want in the current market environment.
Similarly regarding the operating cost guidance, the company has said that it would spend about $ 40 billion in total this year other than a few one-off costs. Now, this is again a near 25 % reduction compared to the $ 53 billion spent in 2014 under the same head. These reductions also imply a $ 17 billion of CAPEX reduction plus a $ 13 billion of operating cost reduction during the 3 year period between 2014 and 2016. And the company also said it won’t require spending anything extra to run the newly acquired BG Group. That’s extraordinary!
Cash flow management:
Although Shell has stayed prudent on capital and operating expenditure, it has not been so when it comes to curbing cash outflow. The management’s priorities for spending cash go in this order: debt reduction, dividends, and lastly capital investments and share buybacks.
Shell has again announced a dividend of 47 cents per share as it did last quarter and even one year ago. That amounts to $ 3.7 billion of outflow when the cash generated from operations was $ 4.6 billion. Up to here it’s fine. But a CAPEX of $ 6.1 billion over and above that can’t be covered without taking more debt which is against the first priority set by the company. And we have not considered any one-time costs here.
If debt reduction had been the top priority of the company, why has the gearing ratio doubled in the last one year? In fact, it has shot up from just 14 % to 26.1 % after the BG consolidation. And the company’s net debt has increased from $ 26.6 billion to $ 69.9 billion within this short span of one quarter. This is serious and needs action.
The sharp decline in earnings at Shell is understandable and obvious given the difference between oil and gas prices that came over the past one year and the weightage of upstream business in the company’s portfolio. The company is also reducing enough costs and generating enough cash to easily survive the downturn that now seems to be mostly behind us. However, the way Shell is dealing with the cash on its hands is dangerous. It should seriously utilize the cash in debt reduction rather than on dividends. Investors would be more pleased by capital gains rather than dividends that leave no cash for reinvestment.