Why Shell Is Slashing Spending After Merger

Quite apart from being one of the biggest takeovers of this or any other year, Royal Dutch Shell (Xetra: A0ET6Q - news) ’s £35billion acquisition of BG Group (EUREX: 1007667.EX - news) was notable for all kinds of reasons.

Among the most important of these was that it catapulted Shell (LSE: RDSB.L - news) into becoming the world’s biggest payer of dividends, overtaking Exxon Mobil (Swiss: XOM.SW - news) , another giant of the oil and gas sector.

The company will hand its shareholders some $15bn this year and, on its own, accounts for around £1 in every £8 worth of dividends paid by FTSE-100 companies. Its ability to continue paying those dividends is, therefore, a matter of the utmost importance to the pension funds and insurance companies who own Shell shares.

Yet Shell’s ability to continue paying those dividends has been called into question following the takeover. Shell’s gearing – the amount of debt it has as a proportion of its capital base – shot up from 14% to 26%. Even (Taiwan OTC: 6436.TWO - news) at ultra-low interest rates, there is a cost to servicing that debt.

Meanwhile, at the same time, Shell needs to carry on investing in its business and those businesses it acquired with BG. There is a cost to exploring for new sources of oil and gas and, once it is found, to extracting it.

So, even for a company with the prodigious amounts of cash generated by Shell, there are lots of calls on that cash – servicing (and in time bringing down) its debt, paying that socking great dividend to shareholders and investing in the business. And, when oil and gas prices fall sharply, the amount of cash generated by the business falls.

Today saw Shell’s chief executive, Ben van Beurden, set out how he plans to meet this challenge. He has unveiled some radical measures – the company is aiming to raise some $30bn from asset sales, which accounts for around one-tenth of its oil and gas production, entailing Shell’s departure from between five and 10 countries worldwide.

Some $40bn of costs will be taken out of the company by the end of the year, involving the loss of some 12,500 jobs worldwide, as has already been announced. And the amount that Shell invests each year will be capped at between $25-$30bn between now and 2020.

All of that, Mr van Beurden argues, means that Shell will be generating some $20-$25bn of cash annually by the end of the decade. There is a big ‘if’ attached to that, though, which is that crude prices will have needed to recovered to around $60 a barrel by then.

The question investors will be asking themselves, aside from whether the crude price can recover to $60 a barrel, is whether Mr van Beurden’s targets are achievable. With (Other OTC: WWTH - news) the crude price at current levels, there is not exactly a queue of buyers for oil and gas production assets, particularly when some of Shell’s peers – such as BP – are also selling businesses.

And the cost-cutting targets are ferocious: Shell and BG’s combined spending in the final year before the takeover was more than $44billion. So there are real questions as to whether Shell can raise as much from asset sales and belt-tightening as it says.

As interesting as these announcements, though, were some of the other things Mr van Beurden announced today. Unlike some other oil and gas majors, he today identified petrochemicals as one of the company’s big growth areas, committing to invest in a major new plant in Pennsylvania that will be fed by natural gas from shale production.

While some will be cynical about the motives behind such investment, Mr van Beurden says one of the main reasons for the project is because customers are demanding petroleum-based products, such as polyethylene, that are produced in a way that is less degrading to the environment. That is one of the aims behind the new plant.

Similar motives underpin another announcement today, namely an investment into “new energies”, including solar, biofuels and wind. Again, these are areas from which some of Shell’s competitors have been withdrawing.

Mr van Beurden confronted immense scepticism in pushing ahead with the takeover of BG Group at a time when oil and gas prices, already low, were falling. Today was his attempt to prove that the deal will pay for itself.

The share price reaction suggests the market is reasonably optimistic he can deliver on what he has set out. The tens of millions of us with a stake in this massive company via our pensions, insurance policies and ISAs will be hoping so.