Shell: What It Will Take To Be Investible Again

U.K.-based oil major Shell (RDS.A, OTCPK:RYDAF) didn’t have a great time of it last year when it came to shareholder relations. With its mammoth dividend cut and poor signaling thereof before it was made, a lot of shareholders ditched the holding. I sold my entire stake and reinvested the proceeds in more Exxon Mobil (XOM).

Below, I outline what I think are the key challenges to Shell being investable at this point.

1. Shareholders Need Faith in Management

The single biggest challenge facing Shell’s prospects right now, in my view, is the low quality of its management from an investor’s perspective. The way that the dividend cut was handled was terrible. Shell is a key holding for many U.K. and Dutch holders, including pension funds and the like. So, a 70% cut just a couple of months after guiding investors not to expect a cut is simply not professional at all, in my view. It doesn’t behoove management of as large and economically important a listed company as Shell to behave in this way.

Management lost credibility with many shareholders, and frankly, it was on such a scale that I won’t have faith in current management again, period. I thought the chief executive ought to have done the decent thing and resigned.

But I also don’t see evidence that current management deserves to regain investor confidence even if one isn’t as critical of how they handled the dividend cut. For example, in comments accompanying the third quarter earnings presentation, the finance chief said:

“we re-based our dividend to protect our balance sheet in response to the profound impacts of the pandemic”.

That feels disingenuous to me. A 70% cut on an ongoing basis is not justifiable purely in terms of pandemic impact. The company seems to continue to message its shareholders without respecting their intelligence.

For me, this is the biggest issue at the moment when it comes to the investment case for Shell. Whatever its asset base or strategy, if it doesn’t have appropriately skilled, reliable management, it’s a speculative punt, not an investment.

2. Visibility on Future Earnings Streams

One of the big debates in the energy sector is future demand for oil and gas versus other forms of energy. I’ve set out elsewhere why I don’t think oil demand is going to fall anytime soon, but there are well-considered and very different perspectives across the spectrum of the debate. For an example, I recommend Tudor Invest Holdings’ piece Royal Dutch Shell: More Than Just Oil And Gas.

One approach, which I would say Exxon is taking, is doubling down on the core business of oil and gas. That is a straightforward play on future oil and gas demand and pricing.

An alternative approach is to move to an asset portfolio which over time produces more energy from sources other than oil and gas. Some are more environmentally damaging, in my view (wind turbines, for example), so I don’t use the moniker “green”. The point is, they’re not from oil and gas. A number of – primarily European – energy majors have committed to this approach. While it’s the case for Shell, it is also happening at BP (NYSE:BP), Total (NYSE:TOT) and Equinor (NYSE:EQNR), for example. So, Shell management is basically moving in lockstep with the European energy sector in its approach here, rather than acting independently.

However, in terms of being investable, the question is what this means for future earnings. Exxon’s approach is simple to understand: one needs to look at future demand, pricing and the company’s production volume and costs. While those are all moving parts, it’s fairly easy to construct different models depending on one’s broad thesis about future oil and gas demand.

By contrast, earnings from the sorts of energy sources Shell is getting into now are much harder to forecast. Markets remain heavily subsidized and immature, so the long-term economics are unclear. I set out in my piece Shell And The Myth Of Oil Major Green Energy my concerns that the company’s strategy was slow to execute, with unproven results. That remains the case. In its third quarter earnings, upstream and midstream results both came with financial figures attached. The so-called “growth” business did not.

Shell now sees its upstream energy business as a cash cow to fund its move into other areas, and pay shareholder distributions. This is clear from a slide it shared with its Q3 earnings.

Source: Q3 earnings presentation

That also matches the approach the company management is taking to its oil production. The CEO is reported as saying that Shell’s oil production probably peaked in 2019. So, the company expects to reduce its output of its cash cow product, meanwhile expanding in other areas whose profitability is unproven and unknown.

The key point here is not whether oil demand peaks, factor outside the company’s control. The issue is that the company is proactively planning to move to a product mix, which seems less profitable, and which is likely, therefore, to lead to structurally lower earnings in the long term, notwithstanding fluctuations in the oil price.

3. A Clear Dividend Logic

Shell set out its new, clear dividend policy with its third quarter result: a dividend increase of c. 4% annually, subject to board approval.

Additionally, it set out (as a lower priority) total shareholder distributions of 20-30% of operating cash flow on reaching net debt of $65 billion. Net debt at the end of September stood at around $73.5 bn. Once the debt comes down, these additional distributions could include both share buybacks and dividends.

That means that, at its current price, Shell has a prospective forward yield around 3.5%, which is decent for an FTSE-100 constituent. The cut has also increased dividend cover, something the company highlighted alongside its inaugural 4% increase last year, although it’s hard to say for now what the long-term cover is likely to be.

So, there is a dividend policy. But I do not see a solid logic in it. First, why a meaty (4%) raise just months after a 70% cut? I just stole your wallet but, hey, here’s your cab ride home! Longer term, why 4%? It sounds attractive to potential investors. But with oil price movements and the unproven economics of Shell’s future focus, setting out a plan for a consistent annual rise lacks logic.

While the clear dividend policy is welcome, I would like for a clear dividend logic also. Currently, I think it’s missing. That matters because if the dividend keeps growing by 4%, sooner or later (perhaps later), the company will come up against the same challenge it faced last year: how to sustain a payout level which has been rising, if oil prices crash?

Conclusion: I Regard Shell As Uninvestable

I sold my Shell position at a loss and reinvested it in Exxon, because I maintain faith in oil and gas as a long-term investment theme but don’t maintain faith in Shell. For me to consider it as being investable again, it would need to demonstrate that management is capable, it has a plan to sustain or increase earnings in so far as it can do so with the levers it can pull (of which oil price isn’t one) and that the dividend has a logic which doesn’t just run it up for years or decades and then heavily cut it again in future. For now, I consider it to fail on all three metrics.

Disclosure: I am/we are long XOM. 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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