Why Neil Woodford Is Avoiding Royal Dutch Shell Plc and BP plc

royal dutch shellCity star Neil Woodford ditched ‘big oil’ from his hugely successful Invesco Perpetual Income and High Income funds over four years ago.

Woodford, of course, had no foreknowledge of the BP (LSE: BP) (NYSE: BP.US) oil spill in the Gulf of Mexico in April 2010. Rather, he was concerned about the sustainability of BP’s dividend, and that of rival Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US).

Having left Invesco, Woodford has been on a two-week roadshow ahead of the launch of his new CF Woodford Equity Income Fund on 2 June. The master investor has been discussing everything from the global macro-picture to individual stocks. And he’s still not keen on BP and Shell.

Big call on big oil

BP’s dividend has been growing strongly since an enforced cut as a result of the Gulf of Mexico oil spill. The board hiked last year’s dividend by 8.8%, and increased this year’s first-quarter payout by 8.3%.

Shell has resumed decent dividend growth after a lacklustre few years following the financial crisis. Last year’s rise was 4.7%, and the board has upped this year’s first-quarter payout by 4.4%.

Many equity income fund managers were impressed with the first-quarter results, and the shares of BP and Shell have recently made 52-week highs of 507p and 2,592p, respectively. Woodford is maintaining his contrarian position that both dividends are at risk.

His main concern is that BP and Shell are funding dividends from asset disposals — “selling the family silver”, as he puts it — and not earnings growth. He’s also sceptical about the companies’ promises to cut capital expenditure; and, if they do, the impact on production growth and, ultimately, the dividend. He describes BP and Shell as “two very stressed organisations”.

Woodford’s position is very simple: when companies are funding their dividends by disposals, he expects a significantly higher yield as compensation. He says: “I don’t own BP or Shell, and I won’t own them until they are much better value than they are now”.

Current valuations

BP is trading at 507p at the time of writing: 10.5 times forecast 2014 earnings, with a prospective yield of 4.6%.

Shell, whose shares trade at 2,444p, is rated at 11.2 times forecast earnings, with the same 4.6% prospective income.

On the face of it, those valuations look good against the wider market. However, it seems it would take a single-digit earnings multiple and a dividend yield north of 5%, before Woodford would even consider adding BP or Shell to his new fund.

Dividends for life

Sustainable dividends are at the heart of Woodford's investing. To help private investors get to grips with identifying great dividend shares, we've just published an exclusive wealth report: "How To Create Dividends For Life".

In this FREE report you'll learn how dividends can provide the foundations for a more dependable portfolio, and discover 5 Golden Rules for Building a Dividend Portfolio.

The report comes with no obligation -- simply click here for your free copy.

G A Chester does not own any shares mentioned in this article.