Today Royal Dutch Shell (RDS.B) is one of the largest oil and natural gas companies on Earth. In the future, however, it hopes to transition along with the rest of the world and become a major global supplier of clean energy. Getting from here to there is going to be expensive. Is it worth it for investors to go along for the ride?
That dividend cut hurt
The global energy industry has been struggling for several years to balance supply and demand, thanks largely to increasing production from the onshore U.S. oil and gas sector. This set the stage for a disastrous 2020, as the economic shutdowns used to slow the spread of the coronavirus led to a sudden and massive drop in demand. Oil and gas prices plunged, with key U.S. benchmark West Texas Intermediate actually dipping briefly below zero.
That is the backdrop for Shell's decision to cut its dividend by 66% in April of 2020. This is not something that investors wanted to see, and likely not something that Shell wanted to do. However, given the headwinds, the company decided that it needed to chart a new course. And in order to keep funding its capital investment plans, it had to trim one of its biggest cash outlays -- the dividend.
To the company's credit, it has already started to increase the dividend again, raising it from $0.32 per American Depository Receipt (ADR) to $0.333 in the third quarter. This was basically meant to reassure long-term investors that Shell has reset the dividend and now plans to get back on the dividend-growth track. But is this energy giant's story really compelling enough to justify a purchase?
A long and difficult road ahead
The big shift at Shell is that the company is looking to get to net zero carbon emissions by 2050. Essentially, it wants to become a much greener company as the world increasingly looks to shift away from carbon-based fuels. There's a lot of work to be done, and it means materially shifting the company's priorities around.
Right now, Shell has capital spending plans in the $20 billion-per-year range. It intends to put around 40% of that toward its legacy oil and gas operations, with the rest going toward what it calls its transition business (up to 40%) and its growth business (up to 25%). On the legacy front, management wants to hone its focus around its best assets so it can reduce production costs. That's clearly a good call with oil and natural gas prices lingering at low levels, but it suggests a stagnant or even shrinking oil business. This is supposed to be the cash cow that helps to fund the company's transition toward clean energy, so cutting back here is good for its green credentials, but perhaps not so good for the company's cash-generation goals.
On the transition side of things, the company is looking to rework its chemical and refining business in a similar fashion. The goal is to shrink from around 14 facilities today to roughly six by 2025. However, the handful of chemical and refining plants that remain are expected to be large, modern, and best-in-class assets. Also in the transition category will be the company's liquified natural gas operations (LNG). Shell believes demand for this fuel will increase by as much as 4% a year for the foreseeable future as natural gas is used to support global carbon emission reduction efforts. That suggests there's some growth opportunity, but it's not clear that it will be enough to offset the plans for the oil and refining businesses.
The businesses that earn the "growth" nameplate in Shell's plans are an interesting mix. Gas stations are an important piece, offering a touch point with end customers, though management is taking more of a retail-oriented view of the business than one centered around distributing its energy. This group will also be an important building block for the energy giant's plans to expand in the electric vehicle charging space. It is also looking to lean more heavily on its energy trading operations and investments in renewable power like solar, wind, and storage. And there are early efforts in biofuels and hydrogen spaces that are getting renewed attention. There's a lot going on here, and some of these elements are basically competing technologies, so it's not clear what pasta being thrown on the wall will stick and what might fall.
All in all, Shell's plan isn't bad, per se, but it's important to recognize the scale of the shift. If you take the company's $20 billion annual capital budget, roughly $12 billion of that is earmarked for its "transition" and "growth" businesses. That's a huge amount of spending on what is a mixture of businesses that may or may not pan out as expected. Meanwhile, the company will be trying to trim its $91 billion long-term debt load down to roughly $65 billion, which in and of itself is a big effort. And during all of this it is going to be pulling back in the oil space, which has long been its most important driver. There are a lot of moving parts here, and finding the cash to get it all done will be difficult -- and in that vein, it's important to note that debt was a key source of capital in 2020.
The risk/reward trade-off
Shell's stock has roughly been cut in half over the past five years, and yet the yield is currently only around 3.9% thanks to the dividend cut. That's generous relative to the market, but well below the yields of peers like Total and Chevron, which both continue to voice support for their dividends. Yes, Shell has big plans for the future, but they represent a massive corporate shift, will not come cheap, and are being made at a time when the company is also looking to materially reduce its debt load.
Shell is likely to muddle through this transition, but there's a material risk that it will be a bumpy ride. And if oil prices rally, it could find itself lagging the energy pack because of a lack of investment in its legacy operations. Most investors will probably be better off looking at other integrated energy majors right now -- at least until Shell has shown some progress along the path toward the new future it is charting today.