Now that oil prices have plummeted to six-year lows - lower than the bottom oil prices touched earlier this year - everyone is starting to wonder whether or not the juicy dividends offered by some of the largest oil and gas companies are sustainable. After all, how can such generous levels of payouts survive a 60 percent drop in oil prices?
There are several ways that oil companies can correct the hole in their balance sheets, aside from boosting revenues through higher production: cut costs, issue new debt and equity, sell assets, or cut the dividend. Since dividends have been considered sacrosanct, the industry has turned to the other options to a very large degree. However, if oil prices stay low, oil companies may soon have to consider their dividend payouts, a once unthinkable concept.
A Sea of Red Ink
For much of the rest of the industry, and especially the larger companies, protecting dividends is a high priority. Instead, cuts to capital spending, selling off assets, and issuing new debt have been preferred.
The oil majors alone have cut spending by $60 billion this year, and slashed thousands of people from their payrolls. But the double-dip in oil prices will likely spark a fresh round of cuts - as much as $26 billion might need to be shaved off in the coming months.
But even that might not be enough.
Asset sales could accelerate. Total (NYSE: TOT) just announced another wave of asset selling, shedding holdings in North Sea pipelines…
Now that oil prices have plummeted to six-year lows - lower than the bottom oil prices touched earlier this year - everyone is starting to wonder whether or not the juicy dividends offered by some of the largest oil and gas companies are sustainable. After all, how can such generous levels of payouts survive a 60 percent drop in oil prices?
There are several ways that oil companies can correct the hole in their balance sheets, aside from boosting revenues through higher production: cut costs, issue new debt and equity, sell assets, or cut the dividend. Since dividends have been considered sacrosanct, the industry has turned to the other options to a very large degree. However, if oil prices stay low, oil companies may soon have to consider their dividend payouts, a once unthinkable concept.
A Sea of Red Ink
For much of the rest of the industry, and especially the larger companies, protecting dividends is a high priority. Instead, cuts to capital spending, selling off assets, and issuing new debt have been preferred.
The oil majors alone have cut spending by $60 billion this year, and slashed thousands of people from their payrolls. But the double-dip in oil prices will likely spark a fresh round of cuts - as much as $26 billion might need to be shaved off in the coming months.
But even that might not be enough.
Asset sales could accelerate. Total (NYSE: TOT) just announced another wave of asset selling, shedding holdings in North Sea pipelines and a gas terminal. The deal will bring in $900 million. In all, Total plans on selling $5 billion in assets this year.
Still, selling assets are only one-off events. The holes in balance sheets could persist. In one scenario, Bernstein analyzed what the situation would look like for several large integrated European oil companies, including BG Group (LON: BG), Repsol (BME: REP), and Galp Energia (ELI: GALP). If oil prices remained around $40 for the rest of this year, the group of European oil companies would take in $132 billion but spend $149, leaving a hole of $17 billion for the year.
The problem only grows worse with time. Nearly half a trillion dollars in debt in the energy industry is due over the next five years. About $72 billion is due this year, but those numbers balloon to $85 billion next year and $129 billion in 2017. Much of that debt is owned by weaker companies who aren't paying out dividends anyways, and could even go bankrupt, but some of that debt is also held by dividend-paying companies.
With Other Options Exhausted, Dividends Could Be Next
The cash flow deficit will need to be plugged somehow, and the longer the oil bust continues, the more likely dividends will be in the firing line. Eni (NYSE: ENI), the Italian oil giant, became the first to cut its dividend payment during this downturn, announcing a cut in March 2015. The firm slashed its payout from 1.12 euros per share to just 0.8 euros. Its share price plummeted by 6 percent on the news, although it clawed back some lost ground.
On August 25, Transocean (NYSE: RIG), the Swiss rig operator, announced plans to suspend its dividend program. As recently as last year the company had been paying $0.75 per share, before slashing it to $0.15 a share earlier this year. Now it will ask shareholders to kill the payout altogether. The company also announced $2.1 billion write-down in asset impairments as well, due to the dramatic slowdown in the demand for offshore rigs. Transocean's dividend yield had reached 4.9 percent, the second highest for the rig sector, as its share price dropped by two-thirds this year.
Given the crash in oil prices, the dividend yields for many oil majors look rather high, especially if oil prices remain low. Of all the oil companies in the world (or even any company, in any sector), it would be hard to believe that ExxonMobil (NYSE: XOM) could ever slash its dividend. It has never done so. In fact, the company even increased its payout during the financial crisis in 2008-2009 and also did so earlier this year, during the depths of the oil price downturn.
So ExxonMobil, if it ever cuts its dividend, will probably be the last to do so. But with oil prices where they are, the Texas-based oil major paid out around $6 billion in dividends in the first half of 2015 while its free cash flow after capital spending sat at just $3.9 billion. It has had to take on more debt to cover the shortfall, but with the triple-A credit rating - higher than even the U.S. government - that shouldn't be a problem for a long time to come.
Some of the other oil majors are not quite as strong. Royal Dutch Shell's (NYSE: RDS.A) dividend yield has jumped to 7.7 percent. That could be an unsustainable level. But just like ExxonMobil, the dividend is considered untouchable for the Anglo-Dutch company, having never reduced it. At $0.94 per share, Shell's dividend payout will account for nearly 90 percent of the company's earnings.
But its earnings will continue to drop if oil prices don't rebound, once again raising questions about the longevity of its payout program. More worrying for a company like Shell, it posted a reserve-replacement ratio of just 26 percent in 2014. That was particularly bad because of the fall in oil prices, making some reserves uneconomical, meaning that the ratio could improve if oil prices bounce back. But Shell was below 100 percent replacement level for several years before that, meaning it was struggling to replace depleted reserves even when oil prices were exceeding $100 per barrel. Lower production will make it difficult to right the ship, especially if oil prices stay low.
Still a Priority
In short, the industry is getting squeezed. But the dividend payments are what make oil companies so popular on Wall Street. Investors love stellar credit ratings, reasonable growth in share prices, but especially those fat quarterly payments. Oil executives will fervently protect their dividend policies, for fear of losing the allure of major investors.
The weakest companies could default on debt payments. More mid-range and stronger medium-sized companies will cut spending, but could eventually slash their dividends if oil prices stay low. The oil majors will guard their dividends the longest. With such a strong resistance to reducing dividends, they will only cut if they run out of all other options. That could still be a few years off.
On the one hand, generous dividends provide solid returns for shareholders, but they also could result in the companies investing too little in growth. Shell's reserve-replacement ratio and its production have fallen for several years, for example. Cutting spending and forgoing new projects in an effort to protect dividends will lead to even lower production in the future, potentially leading to lower returns for shareholders in the long-run than if the companies had rerouted payouts to their spending programs to begin with. Of course, balancing returns to shareholders versus investing in growth is a tough balancing act, but it is not clear why dividends should take a much higher priority.
In any event, if oil prices don't rebound, oil companies may not have a choice but to finally turn to their dividend programs to find fresh sources of cash. And as we seem to be saying each week, it all depends on oil prices.