What does the oil price fall mean for income investors?
As banks begin to signal the threat to their balance sheets of bad loans to the energy sector, we look at whether the fall in the oil price could also place dividends from the “big six” oil firms at risk.
3 March 2016
JPMorgan has announced that its energy sector losses, mainly the result of bad loans, could cost the bank as much as $2.8 billion.
It is a clear sign of the effect the sustained plunge in the price of oil is having on energy firms’ balance sheets, but it is unlikely super major oil firms will resort to cutting dividends, at least in the short-term.
Why are oil majors dodging dividend cuts?
A dividend cut will be the last resort for oil super majors looking to protect their balance sheets.
Super majors, or the “big six”, have historically chosen to slash operating costs and capital expenditure (CAPEX) rather than dump their dividends:
- Royal Dutch Shell has not cut its dividend since 1945.
- ExxonMobil has increased its dividend each year for over three decades, and has paid out a dividend for more than 100 years.
Oil firms’ commitment to maintaining and even growing their dividends appears undimmed.
- After reporting its first quarterly loss since 2002 and deep cuts across its operations, Chevron, the US’s second-largest oil firm announced that the company’s number one financial priority was “to maintain and grow the dividend”.
- BP reiterated its commitment to its dividend policy in its most recent profit slump.
But while oil prices remain depressed and borrowing costs ultra-low most major energy companies appear to prefer to borrow money, in part to cover their dividend, rather than break their dividend promise.
- US oil and gas production companies’ debt more than doubled between the end of 2010 and June 2015, according to data released to the Financial Times by Factset.
Can oil companies afford to keep paying dividends?
In the short-term it appears they can. Most major energy companies, with the exception of Eni, have maintained their dividend policies despite the decline in the oil price and cashflows, which has been ongoing for the best part of the last five years.
While the year ahead is expected to be painful for the oil industry the over supply issue currently dogging the sector is expected to be addressed.
Analysts estimate that the oil price will make a recovery, potentially easing the burden on energy firms:
- A recent Reuters poll revealed the average 2016 price for benchmark North Sea Brent crude was forecast at $52.52 a barrel.
- The Financial Times ran an article which suggested that because of technical factors we might be nearing “peak bear” for oil.
Why are energy company dividends so important?
In a low income world – most developed economies’ interest rates are at or near zero and global equities yield 2.8%1 – it is easy to understand why oil majors’ dividends are in so much demand:
Company Dividend Yield2
Eni SpA 8.2%
Royal Dutch Shell B 8.0%
Total SA 6.0%
- The energy sector makes up a large proportion of the entire market’s yield. In the UK, for instance, Royal Dutch Shell and BP together provide close to one-fifth of all FTSE 100 dividends.
- Income investment managers rely on the sector’s dividends to meet legal requirements to deliver yield wider than the market offers.
What are the risks?
Oil firms’ commitment to paying dividends comes with the caveat that the oil price does indeed recover.
A continued drought will place further pressure on energy companies’ ability to cover their dividends through earnings from day-to-day operations.
As illustrated in our September 2015 infographic, Royal Dutch Shell and BP are among the biggest firms in the UK which have poor dividend cover3.
At the moment that is not a problem, because they can continue to borrow money.
However, according to financial information services firm Markit, a price consistently below $30 a barrel could be the point at which banks’ credit lines to energy firms start to get choked off.
Credit ratings agencies have already fired a warning shot across oil majors’ bows:
- Fitch cut Royal Dutch Shell’s credit rating.
- Standard & Poor's (S&P) has threatened to strip Exxon (XOM) of its perfect AAA credit rating.
- S&P also put all other oil majors’ credit ratings on watch.
In response one of the oil majors, Repsol, has cut its dividend to protect its investment grade rating.
What does it mean for investors?
The short-term noise around dividend cuts won’t stop, but income from oil majors looks safe, for now.
Given the pressure on earnings and prospective yield, it is likely investors will focus on five main themes when looking at investing in the oil sector:
- Balance sheet strength
- Company debt levels
- Revenue exposure geographically
1. MSCI World Equity Index yield as at 25/02/2016.↩
2. ThomsonReuters Datastream as at 25/02/2016↩
3. Dividend cover: The ratio of a company's net profits to the total sum allotted in dividends to ordinary shareholders.↩
4. Dividend Payout Ratio: The fraction of net income paid out to shareholders in dividends.↩
5. Free Cash Flow Yield: An indicator that compares free cash flow and market cap. It is a representation of the income (free cash flow) created by an investment.↩
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