Here are the three main reasons for why I’m avoiding shares in Royal Dutch Shell (LSE: RDSA) (LSE: RDSB):
Weak oil price outlook
Oil prices had a limited rally last week, after OPEC, along with Russia, pledged to freeze oil production at current levels. The Brent benchmark price of oil has risen by 6% from its lows last week, but that is still some 70% below its peak in 2014.
I view the longer term outlook for oil as bearish, given that forecasts point towards an oversupply of around 1m barrels of oil per day (boepd) this year. A substantial rebound in prices seems unlikely as oil producers have been more stubborn at maintaining production levels than many analysts had previously expected. What’s worse, the supply glut is set to worsen, as Iran prepares to make a big return to global oil markets after the lifting of sanctions.
Not long ago, Shell made almost three-quarters of its underlying earnings from oil exploration and production. Now, Shell’s upstream operations struggle to stay profitable. Its 2015 full year upstream earnings have fallen by 89%, to just $1.78bn, on a current cost of supplies (CCS) basis. With oil prices having since fallen significantly below Shell’s 2015 average realised price of $46 per barrel, I’ll be surprised if it doesn’t make a huge loss this year.
Shrinking downstream margins
Bigger refining margins have acted as a cushion against weak upstream profits and bolstered the profitability of most major integrated oil companies. Shell is no exception — its downstream earnings in 2015 rose 56%, to $9.27bn.
Unfortunately, refining margins appear to have already peaked, with many refiners seeing margins decline in the fourth quarter of 2015. This would mean integrated oil companies, and particularly Shell, because of its more sizeable downstream operations, would lose their main buffer against falling oil prices.
Margins are forecast to fall steeply from their historic highs, and initial data seems to support this. BP estimates that global Refining Marker Margins have fallen another $3.20, to $10 per barrel, so far into the first quarter of 2015, which represents a halving of margins from their peak in the third quarter of 2015.
Shell’s 8.3% dividend yield suggests that investors should be nervous about a possible dividend cut. With oil prices languishing in the low- to mid-$30s per barrel, Shell is having to borrow billions to meet its dividend payout commitments.
The company’s dividend futures, which are exchange traded derivative contracts on the company’s future dividend payments, are pricing in a cut of just 7% for 2016. This is not considered to be very high risk, and instead, indicates a strong likelihood that Shell will maintain its quarterly dividend at $0.47 per share this year.
However, for 2017, a dividend cut seems much more likely, with the market pricing in a 40% dividend cut. Cuts to payouts have become all too common in the mining and upstream oil & gas sectors, but very few integrated oil firms have followed suit. That could soon change.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Royal Dutch Shell. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.