Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Giles Parkinson, Global Equities Fund Manager for Aviva Investors, ponders big oil’s dividend dilemma.
It may seem counterintuitive for an equity investor to question the long-term value potential of a group of companies that has paid $192 billion in cumulative dividends since 2012. Yet as oil majors Exxon Mobil (XOM), Chevron (CVX), Shell (RDSB) and BP (BP.) have pressed ahead with lavish distributions, investors have seen their shares in these companies ebb away.
Even if the oil price rose to $60, the majors would need to slash capex to sustain dividends
Capital erosion has occurred because pay-outs to shareholders have exceeded cash generation. BP pays a quarterly dividend of $1.9 billion, equivalent to a seven per cent yield on a $110 billion market capitalisation. BP’s dividend has not been covered by free cash flow since the third quarter of 2014, when oil averaged $104 per barrel against $57 per barrel currently.
Collectively, the oil majors’ cumulative free cash was negative $21 billion last year, while the cumulative dividend was $42 billion. Shareholders may feel richer in the short-term, but should focus on the $21 billion hole and how to plug it.
To cover elevated dividends from free cash flow, the oil industry needs some combination of higher commodity prices and lower expenditure. Few believe a return to $100 a barrel is likely in the foreseeable future: BP expects the oil price to “move sideways” in 2017.
Can the Majors Cut Costs if Oil Prices Don’t Recover?
Their track record is uninspiring. Cost over-runs are common with exploration and development projects. Consider Kashagan in Kazakhstan. Eni, Exxon, Shell and Total are all invested in the development – nicknamed “cash-a-gone” from its third year onwards. The project was discovered in 2000 and expected to cost about $10 billion. The budget now exceeds over $50 billion.
Despite instances like Kashagan, the majors claim to have made great strides towards lowering costs. True, collective capital and exploratory expenditure fell to around $24 billion in the fourth quarter of last year, roughly half the total in 2013. Even if the oil price were to rise to $60, the majors would need to slash capex to $16 billion to sustain their current $11 billion quarterly dividend. For them to produce enough free cash flow to cover the $11 billion, at the current rate of spending, the oil price would need to hit $78, based on their financial reports.
To be sure, the crisis is less acute than a year ago, when oil was at $30 dollars and some feared it could fall as low as $10. Shell’s most recent beat on cash flow was a step forward. Total now pays a greater proportion of its dividend in cash than stock. But risks remain. The switch to electric-powered vehicles could erode demand for oil substantially. The International Energy Association expects electric-powered cars on the road to exceed 30 million by 2025 and 150 million by 2040.
Alternative Energy Fails to Deliver
The oil majors’ efforts to embrace alternative technology to boost profits have been mixed, too. Total’s acquisition of a majority stake in US-listed SunPower Corp at around $20 per share for a total cost of around $1.6 billion is just one blot on the balance sheet. The company now trades at $7 per share, highlighting that an oil company knows as much about wind farms and solar panels as a spirits company knows about fast food.
The deep disconnect requires a radical and bold solution. If these businesses were to run down current reserves rather than constantly drilling for more, the current level of dividends would be sustainable. These companies were unable to increase organic production when oil was at $100 a barrel and annual capex over $150 billion.
The idea would oblige oil companies to abandon their long-held strategy of growth through expansion, an institutional imperative of many years. Warren Buffett described this approach as “the tendency of executives to mindlessly imitate the behaviour of their peers, no matter how foolish it may be”, in his 1990 letter to Berkshire Hathaway shareholders.
The brave new oil major would be run instead on a yield-to-maturity basis to refocus how money is spent across the firm. There would be strategic disposals of assets, but not necessarily a wholesale break-up of the company. Capex would naturally shrink, fewer exploration projects would be launched, and efforts would be made to extract full capacity at existing sites.
It is time for the industry to adopt this approach. Scaling back will be unappealing for companies used to spending billions. But given the headwinds they face, a ‘less is more’ approach has to be for the benefit of shareholders – regardless of any short-term hit to dividends.
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