With interest rates still at historic lows and the stock market soaring, income investors are hard pressed to find good places to put new capital to work.
As a result, high-yield stocks such as Royal Dutch Shell (RDS.A) often attract investors with the promise of mouthwatering yields.
But while there are excellent high-yield stocks out there, a very high yield can also be an important red flag that a company’s fundamentals have deteriorated to the point that the payout may no longer be safe.
Our Dividend Safety Scores can help separate the risky high yield stocks from the safer ones.
Let’s take a closer look at this integrated oil company for our Conservative Retirees dividend portfolio to see if Royal Dutch Shell represents a solid value investment or a value trap that should be avoided.
Founded in 1907 in the Netherlands, Royal Dutch Shell is one of the world’s largest publicly traded integrated oil companies with 13.2 billion barrels of reserves, 23 global refineries, 100 distribution terminals, and 770 supply points.
The company operates with three major segments: upstream (oil & gas production), downstream (refining, petrochemicals, and oil & gas marketing), and integrated gas (the company’s liquefied natural gas or LNG operations).
The class A shares are domiciled in the Netherlands, while class B shares (RDS.B) are domiciled in the U.K. Investors should choose Class B shares to avoid having any of their dividends withheld for tax purposes (the U.K. doesn’t withhold dividends on U.S. investments).
In Q4 of 2016, the company’s upstream operations produced an average of 3.9 million barrels per day of oil equivalent, a 28% year-over-year increase.
Meanwhile, the company’s fleet of global refineries has a daily capacity of 2.7 million barrels per day and 17.3 million tons per year of high margin petrochemicals.
As for the LNG operations, which are expected to be the main growth driver going forward, the company’s capacity is now up to 30.88 million tons per year, up 50% year over year.
As you can see, Shell’s upstream oil business continues to suffer from the worst oil crash in over 50 years.
Fortunately, however, its highly diversified business model still allows it to achieve substantial profits thanks to its LNG and refining/petrochemical businesses.
|Business Segment||2016 Net Income||% Of Profits|
|Integrated Gas||$3.700 billion||51.5%|
Source: Royal Dutch Shell Earnings Release
Like most oil companies Royal Dutch Shell’s sales, earnings, and cash flow are highly cyclical, coming in booms and busts based on energy prices.
Following the bust in oil and gas prices in 2014, business conditions have been challenging, to say the least.
Fortunately for shareholders, management has spent the last several years working hard to diversify its business, stabilize cash flow, and cut costs to the bone.
And thanks to the recent recovery in oil and gas prices, Shell has returned to profitability, despite a continued slide in revenue.
Most of this has come from a major corporate restructuring, which includes several major changes.
First, the company slashed its capital expenditures, primarily by reducing what it spends on searching for and producing new, higher cost oil reserves. That process is ongoing, with Shell targeting 2017 capital expenditures of $25 billion, down 57% since 2013.
Next, Shell diverted funding to lower cost, higher profitability shale oil production, especially to its prolific Permian Basin assets.
Thanks to the oil crash, shale production costs have plummeted as desperation has resulted in an acceleration of new super-efficient technology adoption, such as more efficient rigs, closer drilling spacing, more laterals per well, more frack stages per lateral, and a prodigious increase in frack sand usage (up to 10,000 tons, a trail load, per well).
The company also divested itself of non-core, higher cost assets, to the tune of over $20 billion (with another $30 billion planned over the next two years). These are funds that were spent on its most profitable projects, as well as to sustain the dividend.
Shell has also invested heavily into its downstream business, especially its petrochemical factories. These take advantage of low cost energy inputs to generate high margin products, for which demand is growing courtesy of lower prices.
In addition, Shell launched a Midstream Master Limited Partnership (MLP), called Shell Midstream Partners (SHLX).
This allows it to recoup the cost of its midstream infrastructure (storage and transportation infrastructure) by dropping down (i.e. selling) these assets to the MLP.
Since Royal Dutch Shell is the sponsor, general partner, and manager of this MLP, it benefits from fast growing regular distributions (tax deferred dividends) because it owns 50% of the limited partner units (what investors buy), a 2% general partner stake, and 100% of the lucrative incentive distribution rights (IDRs).
These IDRs grant a larger cut of marginal distributable cash flow or DCF (MLP equivalent of free cash flow) to Royal Dutch Shell as its MLP’s payout grows over time, up to 50%.
In other words, Shell Midstream Partners is a cheap, tax-efficient way to monetize the massive infrastructure base Shell has built over the past century, while still retaining the majority of the cash flow from these stable, cash-rich assets.
However, by far the most important change Shell has made in recent years has been its pivot to LNG production and sales.
That includes the company’s 2015 $70 billion acquisition of BG Group, the world’s largest publicly-traded producer and marketer of LNG.
Why is Shell betting so heavily on LNG? Because it’s a far more stable long-term business with a potentially very bright growth runway.
Thanks to the BG Group acquisition, Shell is now the world’s second largest producer and marketer of LNG (after Qatar).
This acquisition is the main reason that Shell’s production and profits have recovered so