The Oil Crisis Is Even Worse News for Shell and BP

(Bloomberg Opinion) -- The collapse in crude prices has brought into relief the correlation between oil majors’ financial leverage and the valuation of their shares. It’s a relationship that looks like particularly bad news for the bigger European firms.

Investors’ knee-jerk reaction to the downward lurch in the oil price was, naturally, more severe toward the companies that were more indebted. So shares in BP Plc, Royal Dutch Shell Plc, Equinor ASA and Eni SpA suffered more than Total SA and the two big U.S. majors, Exxon Mobil Corp. and Chevron Corp., when European markets closed on Monday.

Investors’ worries about leverage are longstanding. The top five European oil majors have a ratio of net debt to total capital — a leverage measure known as gearing — averaging 28% based on their 2019 annual results. Meanwhile, Exxon and Chevron were at 20% and 15%, respectively, at the full year, according to Bloomberg data.

Valuations based on forward earnings have historically been lower in Europe than in the U.S., and analysts have suggested that leverage may help explain why investors rate the European sector less favorably. As research from UBS Group AG noted ahead of Monday’s sell-off, balance-sheet strength would define which oil majors got “less badly hurt” in a market where there would be no winners.

Despite these dynamics, the most levered of the European groups have been making relatively slow progress at debt reduction, and the latest crisis is only going to hamper this further. BP and Shell’s gearing is already above their own near-term targets of 20%- 30% and 25% respectively. These targets assumed a different environment, and preventing gearing going back up would require some painful compromises around uses of cash.

Shell’s free cash flow in 2019 was only just enough to cover its dividends and debt interest, adjusting for working capital and excluding what it made selling assets. That was with oil prices in the $55-$70 per barrel range, against around $37 now. Capex was also already below the company’s stated floor, and the group has just gone through a colossal efficiency program following the 2016 acquisition of BG Group. As for debt reduction, this is a terrible market in which to be selling assets. True, Shell could scrap its share buyback program, but that would halt progress on reducing the share count and in turn the absolute cost of the dividend.

BP, on the other hand, provocatively raised its dividend last month, anticipating cash from recently agreed-on disposals and from the sale of a putative $5 billion worth of assets yet to find buyers. But the number put on that fresh divestment program must now be in doubt.

The oil crisis should force a fresh appraisal of gearing targets and dividend levels. But investors crave the income, and the pressure to maintain payouts will be immense. The firms with lower leverage may feel they have earned the right to let borrowings tick up as a way of maintaining investment and cash to shareholders. For others, Shell in particular, the room for maneuver is more limited. Defending the dividend is likely to mean finding more costs and capital expenditure to cut, just when investing in the energy transition is the top strategic priority.

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

To contact the editor responsible for this story: Nicole Torres at ntorres51@bloomberg.net

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

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

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