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A spotlight on oil companies and dividend payouts

Many of the energy companies we own have the financial capacity to maintain absolute dividends through a temporary profit dip – whether they elect to do so in the face of economic uncertainty is another matter

25/03/2020

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

The fall in crude oil prices triggered by the breakdown of talks between OPEC and Russia only added to the global uncertainly created by the spread of the Covid-19 strain of the coronavirus. The market has been attempting to weigh up the magnitude and duration of the impact on global trade and the consequent oil price shock has contributed to concerns about the prospects for a liquidity freeze and widespread credit events.

When oil prices crashed back in 2014, the likes of BP and Royal Dutch Shell retrenched. They cut costs aggressively, sold off assets and streamlined their operations to protect themselves from future market slides and remain profitable at lower oil prices. They have thus grown more efficient – generating more cash when prices averaged around $65 (£51) a barrel over the past two years than when they were at $100.

For the last three years, here on The Value Perspective, we have been laser-focused on balance-sheet strength – not because we foresaw the arrival of any global pandemic, but because risk appetites in the market were too high and valuations did not compensate us for the risk of an unknowable future. No-one can ever know what risks lie ahead – and for that reason we always test our balance sheets versus very poor expectations.

As a result, any oil companies we own now have two key characteristics in common – they are well-capitalised and they are ready to weather a period of lower oil prices. The oil majors are also less geared to the price of oil than one might expect as they are vertically integrated – that is to say, they are active along the entire supply chain, from locating deposits all the way to distribution.

In contrast, if the drop in energy prices persists, then highly leveraged exploration and production companies – a part of the oil sector we have avoided – look particularly likely to see significant liquidity and balance sheet stress.

What about dividends?

There is no hiding from the fact that, in any given year, the earnings and cashflows of energy companies are highly sensitive to the broad economic environment. Again, the businesses we own in this sector do have strong balance sheets while many will have the financial capacity to maintain absolute dividends through a temporary profit dip.

Whether or not they elect to do so in the face of economic uncertainty is, of course, another matter. Indeed, if the global economy does experience a major recession as a result of the Covid-19 pandemic, then it is, unfortunately, highly likely that very cyclical businesses may well have to curtail dividend distributions to shareholders in the near term.

Balance sheet protection

As long-term investors, here on The Value Perspective, we absolutely support this course of action. After all, we would much rather see any business we own protect its balance sheet in the face of an economic threat that is difficult to assess – and the current situation would clearly fit into that category – than blindly pursue the maintenance of dividend targets that were set in a completely different environment. Making uneconomic decisions to maintain an unsustainable dividend will ultimately destroy shareholder value.

In the past, we have been perfectly willing to own businesses in our income/yield portfolios that have just cut their dividend. This is because, if we believe the ‘recovered’ yield will be prodigious on the capital we have invested, we are very happy to be patient. That also holds true for businesses we own in our portfolios today, should they experience a cyclical downturn and have to reduce pay-outs temporarily.

The overall impact on the intrinsic value of a given business from a temporary dividend cut is extremely marginal and, as long-term investors, it is important we do not lose track of that fact amid the short-term market noise.

 

Author

Andrew Williams

Andrew Williams

Investment Specialist, Equity Value

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm. 

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