Royal Dutch Shell: 2 Red Flags But A Reliable 7.4% Dividend Yield – Royal Dutch Shell plc (NYSE:RDS.B)

Royal Dutch Shell (NYSE:RDS.A) (RDS.B) has shed 24% in the last eight months due to the indiscriminate sell-off of the entire energy sector, which has resulted from the coronavirus, and the disappointing recent earnings report of the company. As the oil major has posted disappointing earnings reports for four consecutive quarters, it has raised some red flags for its future prospects. On the other hand, the stock is offering a nearly 4-year-high dividend yield of 7.4%, which is reliable for the foreseeable future.

Red flag #1: Flat production

The earnings of Shell fell 48% in the fourth quarter of 2019 over the prior year’s quarter and 23% in the full year due to lower realized prices of oil and natural gas as well as narrower margins in the refining and chemical segments. However, this was not the worst part of the latest earnings report, as all the oil majors are sensitive to the gyrations of the prices of oil and natural gas. In fact, all the oil majors experienced significant declines in their earnings in 2019 due to declines in the average prices of oil and gas.

A major red flag for Shell is its production rate, which has remained flat in the last two years. All the oil majors, such as Chevron (CVX), BP (BP) and Total (TOT), failed to grow their production for about a decade but they have all returned to growth mode in the last two years. The only exceptions are Shell and Exxon Mobil (XOM), which have posted flat production rates in the last two years.

The main reason for the flat output of Shell is its extensive asset divestment program in recent years. Shell acquired BG Group for $53 billion in early 2016. In order to reduce its debt to more comfortable levels and fund its share repurchase programs, the oil major has sold several assets in the last four years. Those divestments have taken their toll on the production of Shell and hence the company has been unable to grow its output, unlike its peers.

Even worse, management has provided a lackluster outlook for production growth in the upcoming years. More precisely, Shell expects its new growth projects to enhance its production by approximately 400,000 barrels per day over the next two years. As this amount is about 10% of the current production rate of Shell, many investors will rush to conclude that Shell is about to return to growth mode. However, it is critical to keep in mind the natural decline of the existing oil fields, which is 3%-5% per year on average. Consequently, the 6%-10% natural decline of the existing oil fields in the next two years is likely to offset most of the expected contribution of the new growth projects. Overall, it is prudent not to expect meaningful production growth from Shell for the foreseeable future.

Red flag #2: Low reserves

One of the biggest challenges for oil producers is to replenish their oil and gas reserves continuously in order to prevent experiencing a steep decline in their production rate. In fact, this risk factor is the primary reason that Warren Buffett has always avoided investing in oil producers (with very few exceptions).

Shell is much worse than its peers in this respect. The oil major posted a reserve replacement ratio of only 65% last year. Even worse, its average reserve replacement ratio in the last three years has been only 48%.

Source: Investor Presentation

Management claims that the 3-year ratio rises to 90% if the effect of acquisitions and divestments is excluded. However, the effect of the excessive asset sales in recent years should not be excluded, as the actual amount of reserves has undoubtedly been affected by those sales.

Due to those asset divestments and the lackluster performance of the upstream segment of Shell, the duration of its reserves has steadily declined for six consecutive years, from about 12 years in 2013 to 7.9 years in 2019. This lifetime of reserves is much worse than the industry average of about 11 years and Shell should do its best to improve its performance in this metric in the upcoming years in order to secure a smooth production profile.

Dividend

Due to the high cyclicality of the energy sector, which is caused by the dramatic swings of the oil price, it is extremely hard for energy companies to maintain multi-year dividend growth streaks. As a result, Exxon Mobil and Chevron are the only two dividend aristocrats in the energy sector. While Shell is not a dividend aristocrat, it certainly has an enviable dividend record, as it has not cut its dividend since World War II. In addition, thanks to the recent correction of its stock price, it is now offering a nearly 4-year-high dividend yield of 7.4%.

ChartData by YCharts

When a stock offers such an exceptionally high yield, the market usually signals that the dividend is at risk. Moreover, Shell has paid the same dividend for 24 consecutive quarters. This signals that either the company is somewhat struggling to maintain its dividend or it does not see promising growth prospects ahead.

However, the free cash flows of Shell are sufficient to cover the dividend by a wide margin. In 2019, Shell enjoyed free cash flows of $20.1 billion, which were higher than the annual dividend payments of $15.2 billion. Moreover, Shell expects to generate free cash flows of $28-$33 billion this year and thus achieve a dividend coverage ratio of about 2.0.

It is also worth noting that the decreasing share count, which results from the excessive share repurchases of Shell, reduces the financial burden of the dividend on Shell. To provide a perspective, the annual dividend payments of Shell fell from $15.7 billion in 2018 to $15.2 billion in 2019 thanks to the reduced share count of Shell. As the company has another $10 billion in its share buyback program, which can reduce the share count by 5%, the financial burden of the dividend is likely to decrease further.

To cut a long story short, the free cash flows of Shell seem to be sufficient to cover its dividend by a wide margin for the foreseeable future. On the other hand, Shell should drastically improve its reserve replacement ratio and return to production growth mode in order to secure its dividend in the long run.

Final thoughts

In contrast to most of its peers, Shell has failed to grow its production in the last two years. The oil major has also failed to replenish its oil and gas reserves in the last six years and hence it now has the shortest lifetime of reserves in its peer group. On the bright side, thanks to the indiscriminate sell-off of the entire energy sector, which has resulted from the coronavirus, Shell is currently offering a nearly 4-year-high dividend yield of 7.4%. As the oil major enjoys ample free cash flows, the dividend can be considered safe for the foreseeable future. Therefore, those who purchase the stock at its current price are likely to be highly rewarded, particularly if the oil giant improves its upstream performance in the upcoming years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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