Shell’s capital allocation program is risky

UK-Netherland energy giant Royal Dutch Shell has for decades been a fantastic investment for long term oriented dividend investors. The company has delivered returns of over 14 % annualized since 1911 and from World War II to 2020, Royal Dutch Shell has never cut its dividend.

For decades, the average dividend yield offered has been in a range of 6 to 8 % and roughly two third of the total performance came from the distributions shareholders received plus from their dividend reinvestments in a business that had the tendency to be undervalued with regard to several metrics.

Then came the COVID-19 pandemic in 2020 with global lockdowns which severely hit oil and gas consumption. In fact, demand dried up during the lockdowns across the world which kept people inside their houses and apartments.

The world was awashed with surplus production of oil, gas etc., and commodity prices in general came under huge pressure.

As we have reflected in one of our previous articles, Sometimes a Dividend Cuts is a good sign.

Cutting its shareholder distribution by two third in 2020 looked as a drastic measure taken by the Royal Dutch Shell Management, but looking at the business financials more deeply, it was a prudent measure to conserve cash and avoid over-leveragging the company.

As we all know, commodity prices recovered substantially since March 2020, Brent oil for instance has been quite steadily marching up from below USD 20 to USD around USD 80 by the end of 2021. Natural Gas prices have even showed stronger upward movements.

Royal Dutch Shell is one of the largest oil and gas producer company and a great beneficiary of the global demand recovery after the COVID-19 pandemic.

Royal Dutch Shell, one of the strongest and most diversified energy company with enviable operations in its updstream, midstream and downstream operations is facing a very nice windfall of huge additional cash flows due to higher commodity prices driven by higher demand.

In addition to that, in September 2021 Royal Dutch Shell has reached an agreement for the sale of its Permian business to ConocoPhillips, a leading shales developer in the basin, for USD 9.5 billion.

The cash proceeds from this transaction will be used to fund $7 billion in additional shareholder distributions after closing, with the remainder used for further strengthening of the balance sheet which means that Royal Dutch Shell will use around USD 2.5 Billions to pay down debts.

These distributions in the amount of USD 7 Billion will be in addition to the shareholder distributions in the range of 20-30% of cash flow from operations which in my understanding means that Royal Dutch Shell plans special dividends. Furthermore, Royal Dutch Shell has a share buyback program ongoing in the amount of USD 2 Billion for 2021 and it’s likely that the company will continue to retire own stocks.

So, at the first sight this looks like a cash rich bonanza for income investors. But let’s keep mindful.

During the commodities decline in 2020 amid the COVID-19 pandemic, Royal Dutch Shell had to cut its dividend by two third which shouldn’t bother long term oriented investors, as it offered an opportunity for the business to readjust, retain more profits, and build itself for a stronger future during the next business cycle.

But I don’t see that happening.

Now, with higher prices and additional cash inflows from asset sales, Royal Dutch Shell is announcing special dividends and share repurchase programs.

We are here not talking about a capital light business drowning in cash like Facebook, Adobe, Alphabet or Microsoft.

Royal Dutch Shell in constrast has permanent capital reinvestment needs and sits on over USD 55 Bn in debt against annual profits of around USD 8 to 12 Billion per year, depending on the commodity prices. There is very little Royal Dutch Shell can do against price fluctuation except ensuring effective and efficient operations and acting wisely with regard to capital allocations.

Royal Dutch Shell is an asset-heavy business where cash is critical. And as we all have seen, especially during downturns in the business cycle or due to sudden demand- and price shocks, oil and gas supermajors are very vulnerable.

Due to the sale of assets and after having cutting back capital expenditures for years, Royal Dutch Shell is down millions of barrels of oil and oil equivalents in proven reserves which are about 6 – 8 years worth of proven reserves. Why not using 50 % of the USD 9.5 Billion from ConocoPhilips to buy additional Natural Gas reserves and the rest in the amount of almost USD 4.75 Billion to reduce debt by around 15 % per cent.

Just thinking of the debt interests which can be saved and used to support dividend increases over time.

Let’s bear in mind that Royal Dutch Shell is facing pressure from a court in The Hague to cut carbon emissions by 45 by 2030 from 2019 levels. My guess is that the management wants to reach that goal by disposing off oil assets and focus more on natural gas production, which leads to lesss emissions.

But how will the company make up for the sold assets when reserves are falling drastically? Where is the point in buying back own stocks with money of sold assets which over time will decrease the production capability of the company? (see also article Good share repurchase programs are rare).

With higher commodity prices and improving global demand, Royal Dutch Shell at least has the possibility to benefit of massively stronger cash flows which can also be used to transform and the strengthen the business. But a well run business should act from a position of strength in any situation.

You are responsible for your own investment and financial decisions. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.

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  1. That’s a very good point you make here. The dividend cut was a drastic measure especially after their history of dividend increases and I would have liked to see that the leadership team would have taken also a pay cut in these uncertain times. I like buybacks when the share price is low. However I’m loosing more and more confidence in the management team. Aah and then there was this ill timed $50+billion acquisition of BG messing up their clean balance sheet. To me looks like management wants to pump up the share price before they retire. Maybe I’m just to critical…let’s see. Time will tell. 2030 we will know more 😃

    • Hi Dan
      The ill-time acquisition of BG and in particular the unnecessary high price (more than USD 50 Bn) was something that bothered me as an investor. BG gave Royal Dutch Shell a strong position in LNG and access to reserves etc., so I had nothing against the acquisition target per se. But they could have acquired that company for USD 10 Bn less, no doubt about that.
      So, quite clearly Royal Dutch Shell has not been a very prudent capital allocator in the last 5 to 10 years. Well will see, have that giant will position itself. And one thing is also clear: if higher oil and gas prices persist and Royal Dutch Shell does not make terrible mistakes, it will be an extremely rewarding investment for years to come.
      Let’s see, how things turned out until 2030:)
      Appreciate you stopping by and thanks for commenting.

  2. Hey buddy, good article !

    Like many oil majors, the company needs to transition but probably even faster than it realises.

    On the other hand, the company has a strong solvency and reducing the share count is not too bad. The way Shell transitioned a lot was by the BG acquisition in 2016.

    I expect the company to do this more going forward: transition by acquisition.

    Until then I am actually quite fine with their capital allocation program.

    I think a minimum should go to building new upstream assets and more towards acquisitions. And during that time I wouldn’t mind special dividends and also buybacks at current prices.

    Looking forward for your next article 👍

    • Hi European DGI
      Thanks mate, for stopping by and commenting.
      Absolutely agree, oil majors need to transition, at a much faster pace than they have been used to.
      Shell made a good move in acquiring BG to become one of the largest integrated gas and oil supermajor. I like the acquisition target but not the price, Shell could/should have re-negotiated the acquisition price in the interest of its shareholders, as did for instance LVMH in 2020 amid the pandemic when they acquired Tiffany. 2016 showed a deep oil and gas price crash and the whole investment case immediately changed. Instead, Shell over-paid and took on a heavy debt burden.
      Shell has so far done a good job in bringing the debt level down. But they could siginificantly accelerate and gain more financial flexibility in the process.
      With regard to share repurchase, yes, the share count will be lowered. But one of the main purpose with buybacks is to lead to incremental EPS-growth. Now when stock buybacks are financed through asset sales which weaken future EPS-growth potential, it kind of looks to me like a zero sum game. We investors won’t see it in the near term, as gas and oil prices are being inflated. But just assuming an oil price of USD 50, EPS-growth potential will be lower than it was before. That’s because assets were sold and CAPEX has been lowered for years.
      Now, it’s well possible that Shell makes faster progress in further deleveraging plus having the “surplus” Cash Flows to also reinvest heavily into the business WHILE at the same time making dividend payments, extra dividends plus share repurchases. That’s of course possible. And as you write, acquisitions could move the needle additionally. However, here again, acquisition prices really matter. I hope they won’t make another EUR 50 Bn + acquisition.


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