Will Royal Dutch Shell Plc raise its dividend in 2018?

Does improving free cash flow mean dividend growth is just around the corner for Royal Dutch Shell plc (LON:RDSB)?

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Following Royal Dutch Shell’s (LSE: RDSB) announcement on restoring its all-cash dividend on Tuesday, is dividend growth on the cards for 2018?

Free cash flow

Due to improving free cash flow, Shell said it would cancel its scrip dividend programme with effect from its 2017 fourth quarter payout, and announced plans for $25bn in share buybacks through to 2020.

The company gave shareholders the option of receiving a dividend in the form of newly-issued shares, known as a scrip dividend, in 2015 after the slump in oil prices. It was a move to increase its financial flexibility as cash generated from its operations then dried up. But now that free cash flow has improved substantially from its lows in 2015, it no longer made sense to issue new shares in lieu of cash dividends, as increasing its share count would eat into its earnings per share.

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Following a major overhaul to costs and recent changes to adapt to a $50+ per barrel oil price environment, Shell has seen a dramatic reversal in its free cash flows. In the first nine months of 2017, free cash flow rose to $21bn (from a negative $16bn a year ago), significantly more than the $15bn required to pay an all-cash dividend.

And going forward, it expects further improvements, with its guidance for free cash flow of between $25bn and $30bn by 2020 with oil at $60 a barrel, up from its earlier target of between $20bn and $25bn.

Oil price recovery

This all sounds great to me, but a sustainable expansion in free cash flow is predicated on stable downstream margins and oil prices staying roughly where they are. Shell has certainly made significant progress in lifting its returns on capital employed, but there are many factors which are outside of its control.

The global oil outlook is very uncertain and oil prices may struggle to stay above $60 per barrel for long. What’s more, downstream margins are likely to remain under pressure, especially in Europe to which Shell has the most exposure.

Still, given the progress already made, I reckon the odds of a return to dividend growth next year are close to 50:50.

BP’s turn

Investors are keenly watching to see when BP (LSE: BP) would do the same and return to an all-cash dividend.

Earlier this month, the company restarted share buybacks to ease the dilution effects of its own scrip dividend. Some analysts see this as a sign that BP could be due to cancel its scrip dividend programme soon, but there’s been no announcement as yet.

Like Shell, BP’s free cash flow has also improved substantially, with underlying operating cash flow in first nine months exceeding its organic capital expenditure and its full dividend requirements. With an all-cash dividend, the oil major needed a Brent oil price of just $49 a barrel to balance organic cash flows in the period.

However, BP needs to be more cautious as its Gulf of Mexico oil spill payments continue to be a drag on its performance. The company also has a slightly higher level of indebtedness, with a net gearing ratio of 28.4%, compared to Shell’s 25.4%.

That said, the company shouldn’t be too far behind Shell in cancelling its own scrip dividend programme.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell B. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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