Eight months on from the $64 billion acquisition of BG Group and Royal Dutch Shell PLC's finances seem to be under greater strain than ever. The Anglo-Dutch oil major's net borrowings stand at $78 billion and indebtedness is a smidgen below management's self-imposed ceiling. Even as the benefits of buying BG are starting to show, the takeover has trapped Shell in austerity measures for the foreseeable future. The good news is that progress is likely to be visible, and that provides a useful story for the shares.
Buying BG just as the oil price slumped put Shell in a straight-jacket. In the first half of 2016, the company had to pay dividends out of debt, reinforcing fears the payout would have to be trimmed. Shell has always maintained that it has ways to deal with this. The claim is looking increasingly credible, even if the Houdini-like contortions are uncomfortable viewing.
Third-quarter results showed cash from operations was $8.5 billion, neatly covering $5.2 billion of investment needs, cash dividend payments of $2.7 billion and a $600 million interest bill. The oil price was little changed on average in the period, but new production came on stream, costs were cut and working capital movements were favorable. Some 12,500 jobs have gone since the start of 2015.
One good quarter is a poor proxy for underlying performance in the oil business. Nevertheless, if crude holds at about $45 per barrel, it's still plausible that Shell can fund its $25-$30 billion of yearly investment without resorting to more debt. Further production gains and cost cuts should help cover dividends and interest. A sustained oil price above $50 would really ease the pressure. If only.
More dramatic relief will have to come from Shell's $30 billion disposal program. If the group can agree, say, $8 billion of sales this year and next, indebtedness would fall substantially. That's not hard to believe.
It's a tense spectacle and the plan is vulnerable to setbacks. No wonder investors are nervous: the shares yield 7 percent on a forward basis, pricing in the high chance of a dividend cut. Yet the medium-term investment story from Shell is pretty clear as cash generation improves and debt comes down.
Contrast that with BP. Its latest results also show it wrestling with a weak oil price and struggling to balance cash generation with investment and dividends. The shares have a similarly punchy yield.
Its balance sheet is stronger, with gearing at 26 percent versus Shell's 29 percent. So BP has more financial flexibility to invest in its future, and a little cushion to deal with any shocks. That makes it a more straightforward play on a recovering oil price.
But it would only take a few big disposals to loosen Shell's debt manacles, leaving the benefits of owning BG more plain to see.
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