Is it time to dump Royal Dutch Shell plc (+31%) and BP plc (+23%)?

Do investors need to pay more attention to the risk of dividend cuts at Royal Dutch Shell plc (LON:RDSB) and BP plc (LON:BP)?

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Oil and gas giants Royal Dutch Shell (LSE: RDSB) and BP (LSE: BP) have been among the top performers in the FTSE 100 so far this year. Shell stock is worth 31% more than at the start of January, while BP is up 23%.

But these gains don’t seem to reflect the weak state of the oil market or both companies’ rapidly-growing debt piles. Are investors turning a blind eye to the risk of a dividend cut in pursuit of the 7% yields available on both stocks?

Cash flow problems at Shell?

Shell’s interim results showed that the firm’s net debt has rocketed from $25.9bn one year ago to $75.1bn today. Much of this is due to the BG acquisition. I expect Shell to be able to refinance a lot of BG’s debt at much lower interest rates than those paid by BG.

But the reality remains challenging. Shell has $10.8bn of debt due for repayment or refinancing during the next 12 months. Excluding the BG acquisition, Shell reported a net cash outflow from operations and capital expenditure of almost $8bn during the first half.

The group then paid out a further $1.26bn in interest payments and $4.7bn in dividends. By my reckoning that’s a shortfall of almost $14bn. The company was only able to square things by borrowing an additional $9.5bn during the period, and reducing its cash balance.

I expect some improvement during the second half of the year. But it’s clear that Shell’s dividend is being funded from debt and cash reserves. Shell is betting that the price of oil will recover to $50-$60 per barrel before its debt levels become problematic.

Oil could remain below $50 into 2017, but will eventually recover. The longer it stays low, the more violently the price is likely to spike upwards when demand does start to exceed supply.

A dividend cut might have been prudent for Shell and could still be necessary. However, I suspect the group’s size and ultra-low borrowing costs will mean that chief executive Ben van Beurden gets away with this crowd-pleasing gamble.

Are things better at BP?

At first glance, the situation appears to be slightly better at BP. The group reported net cash from operating activities of $5.7bn during the first half of the year, nearly twice the $2.9bn reported by Shell.

BP’s outgoings appear to be more modest too. Net cash outflow after operations and capital expenditure was only $1.6bn during the first half. BP’s borrowings rose by less than $1bn, compared to $9.5bn at Shell.

Although BP’s dividend is also being funded by borrowings and the group’s cash balance, it does look more nearly affordable to me than that of Shell.

Buy BP, sell Shell?

While I have concerns about Shell’s rocketing levels of debt, I do think the picture is being distorted by the acquisition of BG. Cash generation should improve rapidly when oil does start to recover.

I own shares in both firms and have no intention of selling either stock. I’m happy to accept the risk of a dividend cut in the expectation of further gains over the next couple of years.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares of BP and Royal Dutch Shell. The Motley Fool UK has recommended BP and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »