How Does Shell Plan To Bring Down Its Leverage?

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RDSA: Royal Dutch Shell logo
RDSA
Royal Dutch Shell

Over the last three years, the commodity downturn has not only hampered the profitability and cash flows of oil and gas companies globally, but has also raised concerns over their ability to meet their debt obligations. While some of the smaller oil and gas producers, who had huge debts on their books, had to file for bankruptcy in the last couple of years, large integrated energy companies, such as Royal Dutch Shell (NYSE:RDS.A), have managed to survive the oil slump, despite the rising debt on their books. In this note, we discuss the reason behind the sudden rise in Shell’s long term debt over the last two years, and how the company aims to bring it down in the coming years. We have a price estimate of $63 per share for Royal Dutch Shell, which is in line its current market price.

See Our Complete Analysis On Royal Dutch Shell Here

The BG Group Acquisition

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In the wake of plunging commodity prices, Shell decided to take a long-term bet on the anticipated growth in global LNG markets by acquiring the BG Group in a $52-billion deal in 2016. The deal would not only strengthen the company’s dominance in the LNG markets, but also enable it access to pre-salt crude oil reserves offshore Brazil, which could contribute to its value in the long term. Further, the deal was initially expected to generate cost synergies of $2.5 billion by 2018, which was revised to $4.5 billion within a few months of the deal completion. While the acquisition had a number of positives for Shell, the company had to raise a significant amount of long term debt in order to finance this huge deal. Below, we present how Shell’s net debt position rose sharply in the early part of 2016, as a result of the BG Group deal.

Just to put things in perspective, Shell’s net debt more than tripled from $21 billion at the end of 2015  to over $66.6 billion at the end of the third quarter of 2016. In consequence, the company’s leverage, or net debt-to-equity ratio, jumped from merely 13% to over 35% during the same time-frame.

Corrective Steps

Even though Shell’s leverage has increased significantly over the last two years, the integrated energy company is aware of its drawbacks and has been working proactively to reduce the excessive debt on its books. For instance, the company has repaid almost $10 billion of its total debt in the last four quarters, bringing down its gearing ratio (same as leverage ratio) to around 30% at the end of the latest quarter. In order to further reduce its long term debt, Shell has been divesting its non-core and/or non-strategic assets over the last few quarters, and is on track to meeting its divestment program of $30 billion, ahead of its targeted time period of 2016-2018. Additionally, it expects its divestments to continue at a rate of at least $5 billion per year beyond 2018. This will not only allow the company to reshape its asset portfolio into a high grade one, but will also enable it to raise financing to pare down its debt obligations.

However, Shell is not putting all its eggs in the same basket. That is to say that the company is not completely relying on the proceeds of asset sales to improve its leverage position. On the contrary, it expects to grow its organic free cash flow to $25-$30 billion per year by 2020 at $60 per barrel in constant 2016 terms. This is $5 billion higher than its previous expectation, implying that the company foresees strong improvement in its cash flow position, which it plans to utilize to reduce its long term debt.

Lastly, Shell plans to restrict its annual capital investment to $25-$30 billion over the next three to four years. In case the commodity prices recover faster than expected, the company plans to cap its investments at $30 billion and use the excess cash flows to accelerate its debt reduction. That said, while Shell has made solid headway in enhancing its capital structure, the company has a long way to go before it can achieve its targeted gearing ratio of 20% and maintain a strong credit rating of AA.

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