Royal Dutch Shell: When Not To Worry About Dividend Cuts

In 1907, Royal Dutch Petroleum merged with Shell Transport & Trading to create a counterweight that could hold its own against John Rockefeller’s growing Standard Oil in the United States that was scaring the bejesus out of European businessmen because Rockefeller possessed an unbridled ambition and cunning ruthlessness to lower the price of kerosene and gasoline by 80% by underselling competitors with lower prices and engaging in transportation rebates that Standard Oil executives went to great lengths to keep secret.

At a time when gasoline and kerosene executives were respecting each other’s turfs and collecting nice profits for themselves so that they could go about life with nice houses, kids in the best schools, and generous philanthropic records, Rockefeller threatened the “everybody wins” business model that existed if you worked in upper management or above at an American or European energy or trading company. Rockefeller had a secret ambition that became apparent through his actions: he wanted control of the entire oil refining market. With 22,000 domestic wells and almost 5,000 miles of pipelines, he almost succeeded (in the 1880s, he got 83% of the world’s oil refinement coming through his Pennsylvania wells).

The Rockefeller threat allowed the Dutch and British to overcome their xenophobic cautionary stances towards each other—technically, Rockefeller retired in 1897, but he was not a man who simply went away. Little did Kessler and Deterding know that their two fledgling companies, upon the 1907 merger, would not only manage to compete with Standard Oil into a 2014 behemoth that would approach the generation of half-a-trillion dollars in annual revenue (the figure last year was $451 billion), but become one of the most legendary income producing securities of all time.

With a 14% growth rate from the merger through the early 2010s, Shell built wealth in a way that almost no other company in the world could over the long term. The average American dentist earned $3,000 per year in 1914.  Had he observed the growth of Royal Dutch Shell from 1907 to 1914, and then visited the R.J. O’Brien international brokerage house in Chicago in 1914 with the order to purchase $3,000 worth of Royal Dutch stock and pay out the dividends directly to him with the instructions that the shares otherwise remain firmly tucked away and never sold, he would have been using a year’s worth of salary to build one of the largest family dynasties in American history. Even though Royal Dutch Shell was a merger inspired as an anti-American safeguard, they didn’t mind American investors purchasing shares through JP Morgan in New York and a few brokerage houses in St. Louis and Chicago.

A century of compounding at a high rate, even with using the dividends for personal use along the way, leads to crazy absurd results. That $3,000 investment would have grown into $3,326,979,191 from share price appreciation alone without factoring in the dividends (if handed off from person to person over the century without having to be divided into more than one person, this year’s worth of 2014 dental salary would have become the 150th largest fortune in the world in 2014). The annual income generated by the 38,372,000 shares of Shell would amount to almost $400,000 in cash dividends per day.

The “game over” mark would have come at the thirty-year point in 1944, when the United States was appearing likely to survive its potentially nihilistic rendezvous across the sea, and the dividend payouts would have started clearing $3,000 in cash dividends each year at a time when the average wage in the United States was $2,600 per year.

But the ride over the past century was not perfectly smooth for Royal Dutch Shell stockholders. When Germany invaded Romania in 1916, the dividend was cut because the Germans destroyed some of the lucrative pipelines. When Germany invaded the Netherlands in 1939, the German Chancellor wasn’t exactly sympathetic to an energy company that was 40% in the hands of Englishmen, and the dividend again took a hit.

Some other troubles showed up in the 1970s and 1980s when production and prices were low, and in the early 2000s when the executive team got caught overstating oil reserves, but when the final score is tallied, holding Royal Dutch Shell for long periods of time in the past century was a life-changing endeavor.

There were four eras of dividend declines, and the price has fallen 30% from peak to trough at least twenty-five times in the past century (price records from 1907 through the 1960s are scattershot), yet this company is associated with high wealth and high dividend income for anyone has held the stock for long periods of time. It is Europe’s version of Exxon, and creating long-term wealth is what it does, even if the growth isn’t perfectly linear.

It is common for income investors to say things like “I automatically sell if I own something that cuts its dividend.” I wouldn’t personally adopt that approach. It says nothing about actually understanding the business you own, and puts you in a position to sell low because most likely the business will be at a rough part in the cycle when it is time for a dividend cut.

The times when dividend cuts should scare you are when you are dealing with companies that have high fixed costs or products that are sensitive to technology, and you see a dividend cut as a result. When a General Motors or Kodak type of company cuts its dividend, you should be looking to see to get out. If Apple cuts its dividend within the next ten years, I’d be worried.

Energy companies, meanwhile, don’t really go away. They tend to have rough points in the business cycle. If Schlumberger cut its dividend, it would suck if that company’s dividends were an important part of your lifestyle, but the correct response (in my opinion) would not be to sell because you know the company is going to make a comeback fifteen to twenty years later. The history of oil companies in particular is littered with dividend cuts, and it’s usually not a predecessor to a bankruptcy, but rather, it tends to represent the bottoming out process before the recovery begins.

I would study the history of Royal Dutch Shell, Total SA, BP, Conoco, Exxon, and Chevron and see how dividend cuts have been a part of their corporate histories, and they have not prevented them from creating wealth over long periods of time (although Chevron and Exxon keep their dividends much lower than they could currently afford so that they can continue to keep their thirty-year dividend growth streaks alive by having a managed payout in place that incorporates a margin of safety for when the business cycle turns).

Then, there’s the whole “diversification” thing that every financial strategy comes back to, and with good reason. If BP happened to be 2% of your income portfolio when the oil spill happened in 2010, you wouldn’t have been happy with the dividend suspension, but you would have prepared intelligently for those kinds of moments, and you could have trudged on without having to do anything. On the other hand, if BP were 20% of your portfolio (and this isn’t that much hyperbole, as BP dividends constituted 10% of British retirement income at the time of the spill), that dividend cut is probably going to carry over and actually affect your real life. How can you act rationally and think long-term in those conditions? Diversification plus knowledge of a sector’s history are the greatest defense mechanisms against dividend cuts I can think of, for those interested in income investing with super long-term time horizons.

Originally posted 2014-07-09 08:00:33.

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