Growing Risk To Dividends In The Oil Patch

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Includes: RIG, USO
by: Gary Bourgeault

Summary

Can major oil companies keep dividends in play?

Where you are in relation to retirement makes a difference.

Considerations on maintaining position in sector.

Long term outlook for oil.

source: yahoo.finance

Without a doubt one of the main attractions of investing in the oil sector is the usually reliable dividends distributed by energy firms. Now that shale oil has disrupted the market for what will be decades, the obvious concern is whether or not oil companies will be able to retain dividends in a price environment remaining under pressure for a long time.

There are several ways to interpret the current market, with most of the outlook being based on the age of an investor and long-term goals.

Someone near or in their retirement years will have to make decisions on whether to remain in the sector or not based on expected dividend revenue, while those further from their retirement years should look more at growth potential over the longer haul.

Each of these has significant risk in this current oil price environment.

Major oil companies

I'm going to focus on the larger oil companies in my general comments on whether or not dividends will be maintained. If the industry is in for a prolonged period of low oil prices, which I believe it is, it'll be impossible for anyone be the largest oil companies to have a chance at keeping their dividends. They'll probably be fortunate to keep them at the current level, let alone increase them as some are asserting is their ongoing priority.

The reason for that priority is most investors have that as the impetus for taking a position in oil companies in the first place.

Struggling to pay debt and cut costs, I don't see how the small and mid-size companies will be able to keep dividends if they're already distributing them; they'll struggle to remain in business, no matter if they want to pay out a dividend or not.

With supply expected to grow faster than demand over the next year, it doesn't appear there will be any meaningful alleviation of downward pressure on prices that would justify the idea dividends for all but the strongest companies won't be under severe pressure.

As for the larger companies, they'll still struggle because of their weakening share prices and concerns over dividends, which could scare a number of investors out of their positions. That's another way of saying the share price will have difficulty finding sustainable support throughout 2016.

Where you're at in relationship to retirement is a key factor

Volatility and risk to companies and dividends make it hard to know the direction to take at this time, because there really isn't a historical road map to give an idea of how this is going to work its way out over time.

There are those who believe there is a road map because they believe this is nothing more than a supply cycle. They're wrong. That may be included in the current market, but it's not the reason for the underlying challenges in the industry.

That said, how investors interact with this market should mostly be determined by whether or not they're approaching or already in retirement.

For example, if a person has a position in Exxon Mobile (NYSE:XOM) I don't see any reason not to keep the holding if dividend income is the reason for taking a position in it. Some may argue a declining share price, but that's only relevant if you're going to sell your position. If the need is felt to divest of Exxon Mobile, it's probably best to sell out of all holdings in oil, as there would be little reason to be in it if Exxon is considered vulnerable on the dividend side.

Maintaining or taking a position in the oil sector

My view is we're not only in a supply cycle, but in the midst of a major disruption to the oil industry as a result of the burgeoning shale segment of the market.

For that reason the idea of buying a dip is a ludicrous one at this time, when accompanied by the fact we're in a very weak and suspect global economy, which contrary to clueless commentators, isn't and can't be decoupled from the U.S. economy.

Younger investors would probably be wiser to ride this out and wait for the time when the eventual oil price uptrend is highly likely to be sustainable. Under these general market conditions and the oil sector in particular, retaining capital is the best move. This is a time to be defensive and not risk a lot.

I don't mean by that older investors should now invest in oil companies, only that, as mentioned earlier, if they're in it for dividends, and are near to or already in retirement, holdings in blue chip oil companies should continue to pay out the dividends
without a lot of risk of them being eliminated or cut.

Short- and Long-term outlook for oil

There is no justification for being bullish on oil at this time, as there are no visible catalysts to offer support to oil prices.

All that is being offered now as a probability is the suppression of shale oil production, while global demand in 2016 increases. The problem there is shale oil has been very resilient, and demand for the next 12 months, especially concerning China, has been downwardly revised. The weak global economy suggests that will probably happen to a lesser degree in other countries as well.

Even if U.S. shale oil does have a drop in production, Iran is ready to bring a lot of supply to the export market, and Iraq, Libya and Indonesia should add some incremental supply as well.

Iraq reported its supply in December soared, and according to Reuters, an Iraqi official said the country is considering raising output even more in 2016. And yet the idea there is a rebalance coming this year continues to be reported as if all of this isn't happening.

Over the longer term, by which I mean closer to a couple of years down the road, there should be some improvement in the price of oil that is sustainable, with the caveat we aren't in a global recession, which is very possible.

Another factor is the thousands of drilled but uncompleted wells in the U.S. that could be brought into production when the price of oil rebounds, which would put a ceiling on how high it goes.

Conclusion

Those with a position in blue chip oil companies, and are close to retirement, should do okay with their holdings. I see no reason to panic and sell. After all, under these market conditions, where else would capital do better if income is the goal?

There is the idea of keeping capital, which is a legitimate one. But there would have to be the belief a large oil company was in danger of having to reduce or eliminate their dividend, if that were to be a worthwhile catalyst to sell.

For those looking to cash in on what will eventually become an extraordinary opportunity for oil, especially on the upstream side, it is probably too early to take a position. We are in a period of extreme disruption and upheaval in the oil sector, and it will take some time before any of us really know what the industry will eventually evolve into.

If an investor already has a position in big, blue chip oil companies, I don't see that having much of a chance of losing capital or dividends, although the weaker of the larger companies need to be closely watched.

Whatever decision is made, it's best not to be driven by fear and emotion, but on the probable future outlook of the companies and whether or not they have a strong chance of maintaining or even growing their dividends, even if the share price remains under pressure.

As long as they bend but don't break, dividend investors should be okay. Metrics to consider are a strong balance sheet, access to credit, and the ability to generate steady free cash flow.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.