Bear market oil prices depressed Q2 earnings and force cash conservation. Oil entered bear market territory late last week, after Brent fell 20% below its 2016 highs. This cast a pall on the entire energy sector, notably Exxon-Mobil (NYSE:XOM), which had the misfortune of reporting earnings that were $0.23 shy of analyst expectations - and $2.5 Billion lower than they were in the same period a year earlier.
Exxon's second quarter drop is unsurprising: the average price of a barrel of oil (as measured by Brent prices) was 26% lower than it was in the same quarter last year, though it improved by 33.6% compared to its first quarter average. Additionally, there was mounting evidence that Exxon management is taking action to conserve cash. Leading us to believe there won't be any major dividend hikes in Exxon's immediate future.
Dividend and Outlook. Its poor second quarter results notwithstanding, the one thing Exxon has going for it is its dividend. With a $3.00 per share annual dividend, Exxon carries an annual dividend yield of 3.33%. This means that Exxon shareholders can expect to receive $333 in annual passive income for every $10,000 they have invested in Exxon. This dividend yield is in the upper-third of the yields of Dow Jones Industrial Average components.
Investors should also note that, for all the doom-and-gloom surrounding oil companies, the average price of a barrel of oil in July ($46.72) was basically flat from its average price in the second quarter ($47.04). This means that, at least for the first month of the third quarter, Exxon could rely on a relatively stable oil price, which is a somewhat reassuring sign for its third quarter earnings.
What should concern dividend investors is the outlook for Exxon's dividend going forward. Exxon only recently raised its dividend from $0.73 to $.075, which is its slimmest dividend hike in the last five years. This signals that its management is conserving its uses of cash, which is unsurprising considering that it has surprisingly below-average liquidity and working capital ratios for a company that was once rated 'AAA' by Standard & Poors.
Meanwhile, in another sign that it's conserving cash, Exxon cuts its capital expenditures ("capex") by 36% in the first half of 2016. That move saved it roughly $6 Billion in cash during this period - but it also cripples Exxon's ability to invest in areas that could help its Upstream revenues, which were much weaker than its downstream revenues in the first half.
In short, by opting to save cash on its Capex in the near term, Exxon is actually capping its ability to boost future revenues, which in turn, would weaken its capacity to increase its future dividend payments. This is a potentially vicious cycle that investors in Exxon (and other oil companies) should be very concerned about.
It's also important to note that the $6 Billion that Exxon saved in Capex was equivalent to the amount that it paid investors in dividends during the first half of 2016. Exxon's Capex was $10.3 Billion in the first half so even cutting Capex entirely would only give Exxon enough savings to cover its dividend for another three quarters.
Investors should also note that Exxon has over $255 Billion in property, plant and equipment. If we assume that much of this has a 10-year average life, then Exxon would have to spend $25.5 Billion in Capex (i.e. a 10% investment rate) just to keep its fixed assets in viable condition - yet its annualized Capex is just $20.6 Billion. It can't just cut its Capex entirely.
Ultimately, this means is that Exxon is running out of ways to cover its generous dividend payments and that, as much as its management is "resolute" in paying a "reliable and growing dividend," it may have to consider curtailing future dividend hikes if macro factors such as the demand for oil and gas prices don't move in a way that's sustainable.
Indeed, one analyst from Wolfe Research mentioned that Exxon needs oil to be at roughly $60 a barrel for it to be able to sustain both its Capex and Dividend. That may be asking for too much: the U.S. Energy Information Administration (NYSEMKT:EIA) is forecasting that crude prices will average just $52.15 in 2017, which is well shy of the $60 hurdle.
Thus, if the EIA's forecast hews close to reality, then Exxon will be forced to do a combination of two or three things: reduce its Capex further (which is an unsustainable course of action), cut its dividend, or issue more debt. Given Exxon's commitment to a "reliable" dividend and limited ability to cut its Capex further, the third seems like its most likely course.
Indeed, Exxon already issued a net of $1.3 Billion in debt during the second quarter. Since Exxon's leverage ratio is below average, this is the most sensible course of action in the short term if it wishes to keep its commitment to dividend stability intact. That said, the market's appetite for Exxon's debt may be waning in light of recent credit downgrades - at the very least, it will cost the company more money in the form of higher interest rate payments if it wishes to issue more debt.
Looking ahead, analysts have a $90.47 target for Exxon, which means that the stock is basically even with expectations. In our view, considering the tepid outlook for oil and the fact that global growth expectations remain sedate, this price target is entirely justifiable. That is, Exxon's curtailment of its capital investment means that it has effectively borrowed from its future, thus limiting its upside.
What's more, the travails of oil prices mean that Exxon's stock is also a bet on the oil price. Considering that oil prices have averaged around $42.28 in the first 7 months of 2016, it would have to average $45.75/barrel to meet the EIA's target of 43.57 for 2016. That's a tall order considering that oil is now in a bear market.
The balance of risks considered, we would avoid buying Exxon shares in the near term because of ongoing concerns regarding oil prices. What's more, despite having a healthy dividend yield, investors cannot be sure that Exxon's dividend will stay where it is - as we've detailed, Exxon will eventually have to make a choice between reinvesting in its business or returning money to shareholders. Borrowing may be a solution for Exxon in the near term but, if oil and gas prices remain in a prolonged rut, abandoning its commitment to future dividend hikes may become more palatable.
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.
Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.