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How Can Royal Dutch Shell plc And BP plc Afford Their Dividends As Earnings Plunge?

Investors are becoming increasingly worried about the sustainability of the dividends coming from oil and gas giants, Royal Dutch Shell (LSE: RDSB) and BP (LSE: BP). The earnings from the two oil companies have plunged substantially in recent months, and there are few signs that a recovery in oil prices is in sight.

Earnings slide

In the third quarter of 2015, Shell reported a net loss of $7.4bn, as it made impairment charges totalling $7.9bn relating to the cancellation of its exploration activity in the Arctic and its heavy oil project in Canada. Even if we ignore these impairment charges, its financial performance was still lousy. Shell’s underlying earnings in the third quarter fell 70% on the previous year, to just $1.8bn. Its upstream earnings fell into negative territory for the first time in many years, producing a loss of $425m, on a current cost of supplies basis.

BP has fared only slightly better, with underlying earnings falling 48% to $1.2bn in the third quarter of 2015. Downstream earnings have improved more substantially at BP, thanks to its geographical mix and the widening of the spread between the price of crude oil and the price of the refined petroleum products that it produces.

Free cash flow

Shell and BP are reacting to lower oil prices by reducing costs and becoming more efficient. They have already reduced annual operating costs by almost $4bn and $3bn, respectively, but they still cannot cover their dividends with organic free cash flows.

With shares in Shell and BP yielding 7.1% and 6.6%, respectively, investors seem to be somewhat sceptical that they can avoid a dividend cut. Marathon Oil and Eni, two oil giants based outside of the UK, have recently cut their dividends in response to the lower for longer outlook for oil prices. And, the limited response to their share prices could imply that cutting dividends may not be as bad as initially feared.

Dividend priority

However, both Shell and BP remain adamant that their dividends ate untouchable. Both companies are preferring to make cuts elsewhere, reducing capital expenditures, exploration expense and everyday running costs. To prioritise dividends, both BP and Shell plan to cut capex by at least 20% by 2016.

BP plans to be break-even on an organic free cash flow basis with oil price at $60 per barrel by 2017, but currently oil prices are still well below that level. Shell, on the other hand, seems keen on balancing cash flows, through a combination of asset sales and reductions in capital spending, whatever the oil price may be.

So far, both companies have done a fairly good job at funding their dividends without increasing their debt levels too much. Shell’s net gearing was 12.7% at the end of the third quarter 2015, which is only slightly higher than the ratio of 11.7% from a year ago. BP’s net gearing rose 5.0 percentage points to 20.0% over the past year, and remains at a relatively low figure.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.