Are big oil dividends sustainable?
Over the past year, oil prices have sunk from above $100 per barrel in the United States to under $45 per barrel. As commodity producers, oil companies are highly reliant on the price of the underlying commodity. Not surprisingly, the dramatic collapse in commodity prices has naturally caused profit margins for companies across oil space, like Chevron (NYSE: CVX), BP plc (NYSE: BP), and ConocoPhillips (NYSE: COP) to fall in tandem.
Stock prices have recovered over the past month, which has alleviated some of the panic, but dividend yields remain at elevated levels not seen since the financial crisis and global economic recession of 2008 and 2009. From the following chart, investors can see exactly how high their dividend yields have risen over the past four years.
Big Oil and the Carbon Disclosure Project
The Carbon Disclosure Project, or CDP, seeks to change the business world as a response to the threat of climate change, and more broadly aims to promote the responsible use of natural resources. CDP has brought together a variety of stakeholders including shareholders, customers, and governments to incentivize companies to disclose their environmental data. CDP then issues companies a score and grade.
Chevron has received good scores over the past few years. It received a 95 and an ‘A-’ in 2014, as well as a 97 score and an ‘A-‘ in 2013. BP received a score of 80 for the 2014 climate change report, which resulted in a ‘B’ grade. ConocoPhillips earned a score of 89 and a ‘B’ grade on the 2014 climate change report, and an 83 score with another ‘B’ grade in 2013. None of the three responded to the CDP’s requests for water and forestry reports in 2015.
Earnings Collapse Places Dividends in Danger
As revenue and profits sink in the oil industry, the sustainability of dividend payments is being called into question. BP reported $1.8 billion of net profit on $55.9 billion of revenue for the third quarter. Its revenue fell a startling 41 percent year over year. In similar fashion, Chevron earned just $571 million last quarter, down nearly 90 percent from $5.6 billion in the same quarter last year. ConocoPhillips is in even worse position than Chevron and BP, because it does not have a refining business, as it spun off its downstream operations. Last quarter, ConocoPhillips posted a $1.1 billion net loss, compared with a $2.7 billion net profit in the same quarter last year.
This is a real problem because the major oil companies have prided themselves on being some of the market’s top dividend stocks. Their high dividend payouts are one of, if not the, biggest reasons why investors both at the institutional and retail levels buy oil stocks in the first place. Management teams know that investors take the dividends very seriously. The reason is because investors typically respond by selling the stock of a company that cuts its dividend. It is not uncommon to see a company lose as much, or more, in market value after cutting a dividend, than the company saves by reducing its payout.
As a result, CEOs have taken the unusual step of directly and clearly addressing the security of their dividend payments in corporate earnings materials and conference calls with analysts. They are very confident that their business models can sustain their high dividend yields, even in a prolonged downturn in energy prices.
Covering Dividends with Free Cash Flow
For the past several years, most Big Oil companies did not generate enough free cash flow (defined by operating cash flow less capital expenditures) to cover their dividend payouts, since oil companies like Chevron and BP have very high capital spending requirements. This was not a problem when oil prices were high; however, now that oil has plunged and cash flow is drying up even further, investors are more closely scrutinizing financial statements in the Big Oil space.
Their plunging stock prices over the past year have caused dividend yields to skyrocket, since stock prices and dividend yields are inversely related. This has stoked fears that the abnormally high dividend yields for companies like Chevron and BP are at risk of getting cut, and this fear is exacerbated by weak free cash flow generation. In response, management teams are aggressively trying to get out in front of the issue and calm investors’ fears about the sustainability of those dividends.
For the most part, companies are trying to prove their dividends are secure by significantly cutting spending. Over the first half of 2015, Chevron cut capital expenditures by 13 percent year over year. In addition, Chevron sold nearly $11 billion in asset sales over the past 18 months. Meanwhile, BP will cut capital expenditures next year to as low as $17 billion per year through 2017, down from $19 billion this year. And, BP is on track to divest $10 billion in assets this year. For its part, ConocoPhillips forecasts $10.2 billion in full-year capital expenditures, down from its prior outlook of $11 billion.
The cumulative effect of these initiatives is to right-size their cost structures to protect their dividends. BP, Chevron, and ConocoPhillips each expect to cover their dividends with free cash flow by 2017. This would be a very important step to ensure their dividends are secure, even when commodity prices decline.
Companies to Watch
In addition, other large-cap integrated oil stocks with high dividend yields include the following:
Royal Dutch Shell plc (RDS-B): 5.3 percent dividend yield
Total SA (NYSE: TOT): 5.6 percent dividend yield
Disclosure: The author is long BP
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.