The oil sector is enduring its worst period for a very long time, with continued weakness in the price of black gold causing profitability at oil majors such as Shell (LSE: RDSB) to come under severe pressure. In turn, this is making many investors understandably nervous regarding the company’s financial future and whether it can survive what appears to be the start of a prolonged decline in the oil production space.
Undoubtedly, Shell is one of the most financially sound oil producers in the world. For example, its balance sheet contains only modest leverage, with its debt to equity ratio standing at just 26% as at the end of 2014. This means that its operating profit of $30bn in 2014 was enough to cover debt interest payments of $1.8bn a very impressive 16.7 times. This shows that even if Shell’s profit were to collapse in the coming years at the same time as interest costs rise due to a tightening of monetary policy, it is very likely that the company will still be able to afford its debt servicing costs.
In fact, Shell’s financial position is so strong that it is going ahead with a $70bn acquisition of sector peer BG. This, Shell believes, will significantly improve its asset base and provide additional profit growth opportunities in future years. Importantly, the acquisition would not put Shell’s financial stability in question and, moreover, it could realistically afford to engage in further M&A activity while asset prices are distressed across the industry. This is backed up by Shell’s free cash flow, which has averaged $9bn per annum during the last three years.
Of course, Shell’s future in a lower priced oil environment is set to be tough. For example, its bottom line is expected to fall by 35% in the current year before rising by 4% next year. However, this would still leave it with a pretax profit of around $17.5bn, which is relatively impressive and would mean that Shell has sufficient capital to reinvest for future growth and also to make generous dividend payments.
On the topic of dividends, Shell’s shareholder payouts are due to be covered just 1.05 times by profit in the current year. While this means that they are likely to be paid at their forecast level for the time being, there is a chance that Shell’s dividends will be cut in future years unless it is able to boost profitability in the medium to long term via either a rising oil price, M&A activity or cost cutting. But, with its shares yielding 7.1%, even a cut in shareholder payouts would still leave it with a relatively high yield.
As for whether a rise in the oil price is on the cards, in the short run it seems unlikely. Although companies such as Shell are cutting back on exploration spend, there is still a demand/supply imbalance which could last over the medium term. However, with energy demand from the emerging world likely to rise over the long term, there is a good chance that oil will return to its $100 per barrel level in the longer term.
In the meantime, Shell appears to have sufficient financial firepower to not only survive, but also to take advantage of the challenges which the industry faces.