Investors were more than annoyed when Royal Dutch Shell slashed its dividend by two thirds. Just last year, the giant oil company announced its plan to pay out huge dividends over the coming five years. Actually, the investors used stronger terms than “annoyed.” They had reason to be annoyed after the strong commitment to the dividend, but maybe they should have previously shown a greater skepticism about the ability of any management to make such a commitment. Times change and perhaps no managements or boards should publicly commit to actions so far ahead of time.
Royal Dutch Shell has a reputation for forward planning. And dividend policy, which is supposed to reflect management’s best long term projections is not something that is trifled with lightly. So what does the significant dividend cut say? Management offered two explanations: 1) it was unwise to pay a dividend that would not be earned. i.e. that would require borrowing to sustain. That would reduce the resilience (a favorite word nowadays) of the company.
Royal Dutch Shell, however, has the borrowing power and resources to pay an unearned dividend as well as carry out other activities during a short period of difficulties. We could see cash flow of $35 billion and capital expenditures of $20 billion during a bad year, which leaves just enough to pay the annual dividend of $15 billion. An optimistic management would not see this as a problem at all. But a 66% dividend reduction suggests less than optimistic hopes for a sharp rebound in demand. Or perhaps instead that increasingly volatile global oil market conditions may become the new normal, therefore making a large dividend imprudent.
Management added another explanation, though: 2) The company also needed the cash resources of the dividend to shift to a position of net zero carbon emissions by 2050. This seems to have puzzled investors even more than concerns about profound future market volatility. Royal Dutch Shell’s management did not explain how cash conserved in this manner would be profitably redeployed to reach this goal. The collateral issue for investors is how seriously to take management’s guidance which assumes a financial policy continuity for many decades in the future long after the retirements of current senior management and directors. Related: China Set To Ramp Up Natural Gas Imports This Decade
Royal Dutch Shell could cease investing in new oil properties, sell off what it owns and put the money into non-fossil energy or just return the cash to its investors. That would get it into a net zero position sooner. Or it could wind down its oil businesses gradually and liquidate the company by paying out dividends rather than retain the money. But with so much money going into the development of oil properties, it is difficult for outsiders to evaluate the company’s new direction, which seems to be: “We want to go green, but not quite yet.”
This ambivalence about capital investment direction puts investors in an uncomfortable position. Those looking for steady, high yields have been served notice. They can no longer depend on this sector for above average dividend yields. More risk tolerant growth investors may also become reticent about a business gradually losing market share in an energy market that is itself slow growing.
Investors who want exposure to the renewables market will not likely do so via investment in oil companies that increasingly own renewables. In this respect oil companies at this stage don’t bring much to the table except their money. And there is plenty of that around from other sources. Also the environmental-social-governance (ESG) investor movement is growing in importance. And this vocal group is decidedly anti oil and all other fossil fuels. Back in the day portfolio managers catering to yield oriented investors could say, “Yeah, those oil companies are big time polluters but where else can you get 500 or 600 basis points over the risk free rate? Well with this dividend cut that argument just went out the window.
Almost five decades ago, the US electric utility industry had a reputation for rock-solid common stock dividends with above average yields. But power plants, especially those located on the east and west coasts, were at that time heavily fueled by cheap oil from the Middle East. Suddenly this formerly cheap fuel first became scarce and then far more expensive. New York’s own Consolidated Edison Company found itself heavily exposed in the early 1970s and did the unthinkable, omitting its dividend. That was the icebreaker so to speak. Others followed.
The key takeaway, to us, is that after the Con Ed dividend cut, yield oriented investors looked at electric utilities differently. They could no longer rely on a dividend even during times of stress. We wonder if, in a similar way, Royal Dutch Shell’s dividend action has similarly broken the ice.
By Leonard Hyman and William Tilles for Oilprice.com
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