Shell Puts on a Big Oil Squeeze

(Bloomberg Gadfly) -- Royal Dutch Shell Plc is defying skeptics and showing that it can afford its dividend. Investors just need to believe it hasn't made too many compromises to do so.

The Anglo-Dutch oil giant generated $9.5 billion of operating cash flow in the first quarter, ample to fund $4.3 billion of investment, $2.7 billion of cash dividend payments and an $850 million interest bill. It even managed to cut debt without the benefit of big asset sales.

This is the third consecutive quarter where Shell has shown it can live within its means. The accounting result was impressive too: $3.5 billion of net income, up from $1.5 billion in the fourth quarter. That's well ahead of expectations, and without the distortion of lots of one-offs.

This was achieved partly thanks to a higher crude price. Last year's acquisition of BG Group also helped, with the gas business performing strongly. Then there was self-help. Shell didn't slacken on cost control despite the tailwinds.

It's getting easier to see the benefits of the BG takeover, rather than focusing solely on the massive borrowing that paid for it. And yet Shell's stock still has a dividend yield of 7 percent, showing investors are nervous about whether the payout is sustainable.

The snag is that while Shell is on an even keel, it's still highly indebted and would struggle if oil prices dived again. At $72 billion, net debt is still a toppy 27 percent of total capital.

Meanwhile, the oil price today is back at $50, against roughly $54 in the first quarter. Shell can live with that. Over the last 12 months, the group has spent about 10 percent more on investment, dividends and interest than its operating cash flow. The oil price averaged around $50 during that period. The next year should see cash flow rise as Shell spends less and benefits from new production coming on stream.

The difficulty would be if oil shifts much below $50 again for a sustained period. It's not clear how much scope there is for Shell to drive out more cost. It has already been pretty aggressive. Capital investment in the first three months of the year was below the run-rate implied by the group's $25-30 billion annual target. This is a capital intensive business and Shell can't just go on cutting without damaging its ability to extract the cheap oil of the future.

The snapshot will reassure those who fret about dividends. But Shell cannot depend on organic cash generation to pay off debt, nor squeeze capex too hard. Fortunately it has another lever to pull: asset sales. Investors will hope Shell keeps its bankers busy in the months ahead.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

To contact the author of this story: Chris Hughes in London at chughes89@bloomberg.net.

To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net.