Oil and gas producers are out of favour with the market at the moment. Environmental concerns mean that a growing number of investors are avoiding such big polluters altogether. Meanwhile, lower oil prices and weaker profit margins on chemicals are putting pressure on profits.
What should investors do? Thursday’s quarterly figures sent the Royal Dutch Shell (LSE: RDSB) share price down by nearly 4%, but my reading of the numbers suggests shareholders should keep a cool head and stay invested.
Still a cash machine
Although the group’s profits fell by 15% to $4.8bn during the third quarter, this was comfortably ahead of analysts’ estimates of $3.9bn. What’s more, underlying free cash flow during the period — which is more important to me as an income investor — was $6.6bn, only 12% lower than the same period last year.
My sums suggest Shell stock offers a sustainable free cash flow yield of about 10% at the moment. That should be enough to comfortably support the 6.5% dividend yield.
Buyback delay?
Shell’s dividend hasn’t been cut since World War II. But the firm is also returning additional cash to shareholders through a plan to buyback $25bn of its own shares. So far, $12bn has been repurchased. Management confirmed today the firm will buyback a further $2.75bn of shares over the next three months.
However, plans to complete the whole $25bn buyback by the end of 2020 are now in doubt, due to “weak macroeconomic conditions.” Bearish investors might take alarm at this. Personally, I’m pretty relaxed about it. Shell remains robustly profitable and is generating plenty of cash. I’d rather slow the pace of the buyback than allow debt to rise again.
The big picture
It’s not fair to consider Shell without thinking about the bigger picture. Climate change, changing technology and carbon taxes could all have a drastic effect on oil consumption over the coming decades.
How does this fit with my need for long-term dividend investments? In my view, there are two factors we need to consider. The first is that, in my view, demand for oil and gas isn’t going to disappear without fair warning. The vast majority of global transportation relies on oil. Gas is increasingly used in place of dirtier coal for electricity generation, as well for heating and cooking.
For the next couple of decades, I believe this situation is likely to remain largely unchanged. Beyond that, I agree that we could see big changes.
However, Shell’s management appears to be planning for this. Oil production is being managed to maximise short-term production and cash generation. The group’s gas assets are being managed as a longer-term strategic asset. I believe gas is likely to outlast oil as a fuel, so this makes sense to me.
Finally, Shell is starting to look seriously at ways of moving into sustainable energy, principally as an electricity producer. It’s too soon to say how this will turn out. And that’s my second point.
The future is unknowable. Many of the companies we invest in could suffer from disruptive changes. I believe that, for most businesses, long-term survival depends on adaptation. Very few business models are completely evergreen.
In my view, Shell is starting to adapt. In the meantime, I’m happy with the firm’s performance and view the stock’s 6.5% dividend yield as an income buy.