This Energy Dividend Name Continues to Come Out of Its Shell

Energy stocks are benefiting from a major tailwind. Global consumption of oil and gas is recovering strongly from the pandemic this year and as a result, the prices of oil and gas have rallied to 7-year highs. Royal Dutch Shell has greatly benefited from this tailwind and the stock has essentially doubled in the last 12 months. Nevertheless, despite its steep rally, the stock is still offering a 4% dividend yield and high future return potential. Therefore, investors should consider purchasing the stock around its current price. Just like all the other oil majors, Shell incurred a severe downturn in its business last year due to the coronavirus crisis, which caused an unprecedented collapse in the global demand for oil, from 101.1 million barrels per day in 2019 to 92.4 million barrels per day in 2020. Thanks to the massive distribution of vaccines worldwide, however, the energy market is recovering strongly from the pandemic this year. According to the latest report of the Energy Information Administration, global oil consumption is expected to surge from 92.4 million barrels per day in 2020 to 97.4 million barrels per day in 2021 and essentially to the pre-pandemic level of 101.0 million barrels per day in 2022. The ongoing recovery is a major factor behind the rally of the price of oil. The other factor behind the rally is the discipline of OPEC and Russia, which implemented unprecedented production cuts last year to provide support to the price of oil. The cartel has begun to raise its output this year, but at a markedly slow pace, with the intention to return to the pre-pandemic level at the end of 2022. This stance has rendered the oil market tight and it has led the oil price to climb to a 7-year high. A similar situation has led the price of natural gas to a 7-year high, as well. The recovery in the demand for natural gas is so strong that producers have hardly been able to catch up with the rising demand. The natural gas market is even tighter in Europe, where Gazprom, the dominant producer, has kept the market tight. Shell has greatly benefited from the steep rally in commodity prices. In the most recent quarter, the upstream segment of Shell more than doubled its earnings and thus the oil giant grew its earnings per share 69% sequentially. As oil and gas prices have rallied further after the end of the second quarter, Shell is likely to roughly quadruple its earnings per share this year, from $1.24 in 2020 to an 8-year high of $5.20. Growth Prospects In early 2016, Shell acquired BG Group for $53 billion and thus significantly increased its gas production. However, in order to fund that expensive acquisition, the company divested many of its assets. Those asset sales took their toll on the production of Shell, along with the natural decline of its wells, and thus the oil major has failed to grow its production in the last three years. Moreover, since the onset of the pandemic, the transition of the energy market from fossil fuels to renewable energy sources has accelerated more than ever. In this context, Shell has announced a major transformation plan. It will transform its refining portfolio from 14 sites to six energy and chemicals parks and will reduce its upstream portfolio to nine core positions, which will generate more than 80% of the cash flows of the upstream segment. Shell also expects to consume approximately 75% of its proved oil and gas reserves until 2030. This historic transition has rendered the future results of the company somewhat more unpredictable, as the company will move to unchartered waters. On the other hand, as long as oil and gas prices remain elevated, Shell will continue thriving. It is also worth noting that Shell has drastically reduced its operating expenses in recent years and has invested in high-quality, low-cost barrels. This high-grading has rendered Shell more profitable at a given level of oil and gas prices than it was in the past. Overall, due to the high comparison base that will be formed this year from the 8-year high earnings per share of Shell, it is reasonable to expect the earnings per share of the oil major to decline by 1% per year on average over the next five years. Dividend Analysis Until last year, Shell had the most impressive dividend record in the energy sector. The company had not cut its dividend since World War II. However, due to the pandemic, the company was forced to cut its dividend by 66% in May 2020. On the other hand, Shell is recovering strongly from the pandemic and thus it has raised its dividend three times since the dividend cut. As a result, it is now offering a quarterly dividend that is essentially half of the pre-pandemic dividend ($0.48 vs. $0.94). Moreover, although the stock has essentially doubled in the last 12 months, it is still offering an attractive 4% dividend yield. Given the solid payout ratio of 37% and the healthy balance sheet of the company, the dividend should be considered safe in the absence of a severe downturn. Value and Expected Return Due to the high cyclicality of the energy sector, investors should pay special attention on the valuation of energy stocks. During boom times, oil stocks trade at much lower price-to-earnings ratios than the broad market. This is true for Shell, which is currently trading at a price-to-earnings ratio of 9.3. We believe that a fair price-to-earnings ratio for the stock is around 12.0. If Shell reaches our fair valuation level over the next five years, it will enjoy a 5.2% annualized expansion of its valuation level. Given a 1% annual decline of earnings per share, a 4% dividend and a 5.2% annualized expansion of its valuation level, Shell is likely to offer a 7.7% average annual return over the next five years. This return should be attractive for income-oriented investors, particularly given the generous dividend yield and the rich valuation of the broader market.

This Energy Dividend Name Continues to Come Out of Its Shell

Despite its rally, Royal Dutch Shell remains attractive thanks to its generous dividend and its expected 5-year total return.

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