This Oil Major Tops Its US Peers

11/11/2011 10:00 am EST


Josh Peters

Editor, Morningstar DividendInvestor

If you’re an income investor who wants some energy exposure, your best opportunity is with this Dutch conglomerate, says Josh Peters and Allen Good of Morningstar StockInvestor.

Royal Dutch Shell (RDS.B) is unlikely to increase its dividend as fast as its US supermajor peers, but its high current yield—roughly double that of ExxonMobil (XOM)—provides a worthwhile trade-off for income-oriented investors.

Success in multiple geographies and with multiple technologies shows Shell’s ability to thrive in the environment of shrinking energy resources. However, its new projects also highlight the greater level of technical expertise and inherent challenges.

For example, its Mars B project in the Gulf of Mexico will hinge on delivering production from technically challenging fields at water depths of 950 meters. Further, offshore discoveries in Australia will rely on new technologies such as floating liquefied natural gas production—technology with an essentially nonexistent operational record.

On the whole, we expect production and reserves growth to be slow in the coming years, with growth coming heavily from the gas side (including some large LNG projects).

On the downstream front, Shell is actively trying to cut costs and improve returns by creating a leaner and more efficient business after years of declining returns of capital.

This has included shutting down refineries with more than 700,000 barrels per day worth of capacity during the past two years, as well as moving increasingly toward an indirect ownership model with respect to its marketing operations. These moves place more of its downstream focus on its chemical operations, the company’s standout downstream business.

As a result, we expect the Shell’s downstream restructuring activities to bear fruit in the form of higher profitability and returns on capital during the next few years.

Like its fellow supermajors, Shell is conservative by nature and therefore maintains a strong financial position. Midway through 2011, its debt-to-equity ratio stood at 25%, and its gearing ratio (debt divided by liabilities plus equity) was 12%.

Shell is also able to generate strong cash flows regardless of commodity price volatility. With a long-term planning horizon, the company has maintained high investment levels even when commodity prices dip.

Although Shell’s payout ratio (41% based on 2011 analyst consensus estimates) is somewhat higher than that of ExxonMobil or Chevron (CVX), this primarily reflects a greater emphasis on dividends over share buybacks. We think Shell strikes a good balance between dividend safety and shareholder returns.

While a 20-year streak of increased dividends (taking currency fluctuations into account) ended in 2009, we estimate Shell sustained an 8.6% growth rate for shareholder income during that time. Dividend increases have been on hold for the past three years, as excess cash flows have gone to reduce debt and fund increased capital spending.

From here, though, Shell expects to raise its dividend in line with the operating growth of the business, which we estimate at 5%—6% a year as a long-run average.

Our Dividend Buy price of $65 requires a small discount relative to our fair value estimate of $69. This reflects a long-run forecast uncertainty rating of low, as well as the stock’s above-average yield. At $65, the shares would yield 5.2%, and present the potential for 10%—11% average annual total returns.

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