Higher inflation could enhance Shell’s income appeal

Inflation is arguably one of the biggest dangers facing investors at the moment. Although it is currently only 2.3% in the UK, forecasts from various entities such as the Bank of England say it will hit 3% or even 4% by the end of 2018. Added to this is the potential for a relaxed fiscal policy in the USA, which could mean higher inflation not only in the UK, but also around the world.

Stocks with high dividend yields and fast-growing dividends could become more in-demand. Shell’s (LON:RDSB) dividend yield of 6.8% is among the highest in the FTSE 100, while its prospects for dividend growth are high. Best of all, though, Shell is assuming an oil price of $60 per barrel in its projections. Given the uncertainty in the oil sector, I think this is a realistic medium-term target to have. It could mean fast-growing free cash flow and a much higher dividend.

Inflationary pressure

Predicting what would happen after the EU referendum was difficult. As it turns out, few of the Armageddon-type scenarios have proven correct thus far. However, one consequence of Brexit has been a severe weakening of sterling which may not be over just yet. In turn, this has caused inflation to creep higher, since imports are more expensive than they were before the referendum. Now above the Bank of England’s target of 2% and only 140 basis points lower than the FTSE 100’s yield, rising CPI inflation could spur investors on to purchase dividend shares.


In addition to weaker sterling causing higher inflation, I also believe Donald Trump may be the catalyst for the global economy to move out of its deflationary period. This has lasted for almost a decade and has allowed Central Banks to pursue loose monetary policies without inducing high levels of inflation. However, his desire for a loose fiscal policy via low taxes and high spending could push inflation higher. While it may or may not be exported across the globe, I don’t feel the Federal Reserve will be able to stay ahead of the curve due to time lags and inhibitions following the global financial crisis.

Is oil the answer?

Oil companies may not seem like an obvious means of countering higher inflation. The Brent oil price remains at just $51 and could move lower in the short run. Doubts remain about whether OPEC and non-OPEC nations will extend their supply cut beyond the midpoint of 2017.

If they do, the supply surplus of the last couple of years may be not only eroded, but rather a supply deficit may come into play. This would be likely to put upward pressure on the oil price and could mean higher profitability for the sector, as well as rising dividends. However, if an extension to the original 6-month agreement does not come about and oil supply rises, demand may be unable to keep pace in future months. This could mean oil edges lower and remains volatile.

Given this uncertain outlook, it must be stated that income investing in the Oil & Gas (or wider resources) sector is not for the faint hearted. High yields and fast-growing dividends may be possible, but they are unlikely to be viewed as ‘probable’ for a little while yet.

Shell’s appeal

I think Shell has adopted a sound medium-term strategy. It has based all of its assumptions on an oil price of $60 per barrel. In my view, that seems to be a reasonable assumption, given the prospect of a reduction in supply in the near term. Further, the company expects to deliver significant growth in free cash flow by 2021. While its free cash flow has been around $5 billion per annum (not including divestments) in the three years to 2015, Shell expects its free cash flow to rise to as much as $20-$25 billion per annum in the three years from 2019-21.


The reason for such a large increase in free cash flow is a focus on lower-cost projects which could have operating costs as low as $15 per barrel. Shell should also register a fall in capital expenditure as it moves through its project cycle, which should mean a rise in free cash flow even if the oil price fails to do likewise. Although it is difficult to put an exact figure on the proportion of additional free cash flow which could be paid to shareholders as a dividend, I think it is fair to assume the company is likely to offer an above-inflation rise in dividends over the medium term.

Risk/reward

Although the risk of buying an oil stock such as Shell for its dividend appeal may be high, so too is the potential reward. Not only is the company forecast to rapidly increase free cash flow and potentially pay a higher dividend over the medium term, its dividend yield today is also relatively high. At a time when the FTSE 100 yields 3.7% and inflation is 2.3%, Shell’s yield of 6.8% stands out. It means the company could halve its dividend in the event of a declining oil price and still compete with the main index based on income return.

As well as this dividend potential, Shell also offers good value for money in my view. It has a prospective P/E of 15.1 using FY2017’s forecast EPS, which falls to 11.9 using FY2018’s forecast EPS. I feel this indicates that as well as high income appeal, Shell also offers the prospect of a rising share price.

Outlook

With CPI inflation already rising and forecast to reach 3% or even 4% by the end of next year, I believe dividend shares could become more popular with investors. This could lead to share price gains – particularly for those companies which offer the potential for inflation-beating dividend growth.

While the volatility and uncertainty present in the Oil & Gas industry may make it seem like an unlikely place to find an appealing income stock, Shell’s prospects in this area are very bright. Its assumptions for the oil price are relatively conservative, while its scope for higher free cash flow is high. This could fund a rising dividend to add to its already high dividend yield. Trading on what I believe is a fair valuation, this makes Shell a strong income stock for the medium term.