The spread of Covid-19 has caused volatility across financial markets in recent months, but the energy sector has a second crisis to deal with.
Just as the coronavirus outbreak was intensifying around the world, talks broke down between Russia and the Organisation of the Petroleum Exporting Countries (OPEC) over limiting oil production. This led to a dramatic fall in crude oil prices, from over $50 per barrel at the start of March to nearer $20 by the end.
Oil prices then took a further tumble in April, even turning negative for a brief period as contracts for May delivery expired. Unlike Brent oil, contracts for West Texas Intermediate – the US benchmark – are settled by physical delivery, with the owner of the contract on the day of expiry receiving the barrels of oil. As the May contract approached expiry, there was a rush to offload these holdings to avoid having to incur storage costs. (For more on this, see Problems in store: what’s going on with oil prices?)
The recent negative prices are therefore largely due to technical factors in the North American market. Longer term oil prices are more critical for oil companies and these have remained positive.
Nevertheless, investors have been attempting to weigh up the magnitude and duration of the Covid-19 impact on global trade and demand for oil. The sharp price drop has contributed to concerns about the prospects of a liquidity freeze and widespread credit difficulties for companies operating in the sector.
But this isn’t the first time in recent years that oil companies have had to deal with a sharp oil price shock.
Many oil majors have become more efficient
When oil prices crashed back in 2014, major oil companies like 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.
This meant they became more efficient – generating more cash when oil prices averaged around $65 a barrel over the past two years than when they were at $100.
We have been laser-focused on balance sheet strength over the past few years. This is not because we foresaw the arrival of any global pandemic, but because the market’s willingness to take on risk seemed 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 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 sensitive to the price of oil than one might expect because they are, in the jargon, “vertically integrated”. That is to say, they are active along the entire supply chain, from locating oil deposits all the way through to selling petrol.
Other parts of the energy sector look more vulnerable, in our view. If the drop in oil prices persists, then highly indebted exploration and production companies look particularly likely to see significant liquidity and balance sheet stress.
What does this mean for dividends?
There is no hiding the fact that, in any given year, the earnings and cash flows of energy companies are highly sensitive to the broad economic environment. As value investors looking for income, the businesses we favour in this sector have strong balance sheets and many will have the financial capacity to maintain absolute dividends through a temporary profit dip. Whether or not they choose to do so in the face of economic uncertainty is, of course, another matter.
For example, at the beginning of the month Royal Dutch Shell cut its dividend for the first time since the second world war. The annual pay-out will fall from almost US$15 bn to just over US$5 bn, freeing up US$10 bn of capital.
This will allow Shell to protect its balance sheet in an uncertain price environment, and also to facilitate the energy transition as Shell increases its exposure to the low-carbon energy sector. The theory is that as the external environment improves, the requirement to protect its balance sheet would diminish and this would allow the income to grow.
As investors who take a long-term view, we support this type of action. We would much rather see a business protect its balance sheet in the face of an economic threat 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 invest in 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 dividend cut is extremely marginal. As long-term investors, it is important we do not lose track of that fact amid the short-term market noise.
A foundation for growth
Clearly, dividend cuts do harm income in the short-term. This is very difficult as many retirees and investors rely on equity income to cover their cost of living.
One final observation on the UK market overall: coming into this crisis, the market yield was sufficiently high to weather a substantial cut and still be among the most attractive income-based investments available to investors. For example, a market-wide cut of 30% would leave the UK market yield at 4%, which is not far off the long-term average.
From an equity perspective, there will be few markets in the world that yield as much as the UK. And when you compare the UK market to gilts or any other income-generating alternative, the dividend yields of both the FTSE 100 and the FTSE All-Share remain relatively attractive in the context of global stock markets.
Further reading: Oil exporting countries and what investors should know