Shell Stock: Is Royal Dutch Shell plc’s 9.3% Yield Safe?

Shell StockThis Is Bad News for Shell Stock

A few weeks ago, I heard from a friend who had bought shares of Kinder Morgan Inc (NYSE:KMI) and Royal Dutch Shell plc (ADR) (NYSE:RDS.A)(NYSE:RDS.B). He figured Kinder Morgan and Shell stock—two bellwethers of the oil patch—would be a great buy. He pulled the trigger back in November “for the yields,” which were around 8.8% and 7.7% at the time, respectively.

The big yields didn’t faze him, but they should have. What happened next was a tough lesson for the novice investor: big yields come with big risk.

Last month, citing the impact of falling oil prices, Kinder Morgan cut its dividend 76%. The news sent shareholders fleeing, with KMI stock plunging 13% since the announcement. (Source: “Kinder Morgan Announces 2016 Outlook,” Kinder Morgan Investor Relations, December 8, 2015.)

And Kinder Morgan isn’t the only victim. The whole industry has tightened its purse strings like a pitbull with lockjaw. Oil stocks like Transocean Ltd, Chesapeake Energy Corp, and Crescent Point Energy Corp once all sported tall yields. However, over the past few months, low energy prices have forced these firms to slash or suspend their distributions.

You shouldn’t be shocked. In the face of low oil prices, drillers need to conserve cash. The scary part is that more dividend cuts might be looming. Worse still, I suspect the next announcement could come from one of the biggest players in the whole sector: Royal Dutch Shell.

For Shell, cash flow is the problem. In the first three quarters of 2015, Shell earned only $1.6 billion in profits. The firm, however, paid out $7.6 billion in dividends.

Those numbers don’t add up. Shell cannot maintain this payout without burning through its cash reserves. Even if management were to cut the dividend, the payout would still be too rich.

But it gets worse.

Oil prices are plunging. Last week, the company warned this would cut fourth-quarter profits by 40% from a year ago. Earnings, executives predict, will come in between $1.6 billion and $1.9 billion—well below analysts’ expectations. (Source: “Shell warns of 40% slide in fourth-quarter profits,” Financial Times, January 20, 2016.)

The smart money is worried, too. This week, the yield on Shell stock topped 9.3%, closing in on a new record. Investors don’t believe the payout is sustainable and they’re demanding higher returns to justify the risk.

There are options, however. Shell stock’s tidy balance sheet means it can still raise debt to fund its payout. Management could trim expenses further by deferring projects.

The company is still mulling over several big investments. In particular, this includes Vito in the Gulf of Mexico, Bonga South West off Nigeria, and a Pennsylvanian petrochemicals project. One or more of these could yet be scraped, saving much-needed cash.

But all of these options leave Shell as a weaker company. Raising debt could backfire if oil prices remain low. Shelving projects, though good in the short-term, means investors will have to dial back their growth expectations for RDS stock.

The bottom line: yield hogs should be worried. To conserve cash, Shell could be forced to trim or cut its payout completely. If oil prices don’t rally soon, brace yourself for smaller dividend yields.