Dividend Investors have long flocked to the oil patch in search of dividends. In fact buying and holding large, integrated oil companies and reinvesting the dividends has been a proven pathway to generate a hefty dividend income stream as well as long term returns. Exxon (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A), BP (NYSE:BP) and Chevron (NYSE:CVX) and their predecessor firms have been amongst the highest returning firms over the better part of the last 50 years.
In a study by Jeremy Siegel in his book, the Future for Investors, Siegel notes that the returns of Shell and Exxon were above 13% annually from 1950 till 2003, while even Chevron and Conoco Phillips managed very respectable low double digit returns over the same period. Exxon was so good, in fact, that it had the 4th highest return from 1950-2003 of the top 50 US companies.
There was no real magic to these returns. They were largely as a result of accumulating and steadily reinvesting the large dividends of these massive oil giants over the better part of 50 years. However the key aspect of this strategy was to hold shares and reinvest dividends even in periods of declining oil prices, when share prices of these oil companies go materially lower.
Investors typically become so bearish on the share prices and prospects for big oil companies during oil price declines that they send their shares to dismally low prices. However investors that can hold and reinvest dividends pick up significantly more shares along the way. Once the bear cycle ends, these investors eventually get the benefit of inflating oil prices, materially higher share prices and significantly higher dividends from more shares held. This is a standard pattern that plays itself out across cycles of recession and economic growth and oil price booms and busts.
Of course, this principal only works where the oil company's dividend is preserved. The return accelerator from declining share prices can only turbo charge dividends and total returns if the dividends can be paid through the cycle and investors pick up a proportionately large number of shares. With Conoco's (NYSE:COP) massive 66% dividend cut recently, the question arises as to whether this time"its different" and that holding these oil businesses through the cycle no longer works.
I'd argue that is not in fact the case. What's become clear in the depths of this current cycle is that its only the best of breed integrated oil majors and not pure play exploration and production (E&P) firms that have the breadth of operations and the consistent returns on capital through the cycle to allow for dividend preservation.
This is an observation that's become apparent with Conoco. COP has been less protected from declining oil prices in this current downturn as a result of the spin off of its refining business, Phillips 66 (NYSE:PSX).
Exxon, Shell and Chevron's refining operations have helped insulate their respective exploration and production profits during current price declines. These businesses are still able to generate refining profits from lower oil prices. which help to preserve overall company profitability.
The contrast between Conoco and Exxon couldn't be more stark. Exxon has significantly boosted refining margins, and generated close to $2B in quarterly refining profits in the last few quarters. Refining contributed more than half of Exxon's total quarters profits in Q3 2015.
Exxon is still hurting from falling oil prices, but the overall business is still solidly profitable and generating significant free cash flow. Shell and Chevron are also still profitable in spite of declining share prices and have still been able to preserve dividends thus far in the cycle. Conoco Phillips on the other hand is in a world of pain. The business lost $1B in 2015 and is generating negative free cash flows to the tune of $3B dollars. It's no wonder that the company has to slash dividends.
Eventually, this depressed cycle of oil prices will also right itself. I expect prices to be higher than they currently are within the next few years. While the exact duration of the oil price decline is hard to predict, higher-cost oil supply (typically shale oil) will likely be progressively withdrawn from the market, given its relatively high marginal cost. In many instances, shale producers have operations that are heavily financed with debt, with limited long run cash reserves. As such, these producers do not have the financial means necessary to withstand a prolonged downturn. Thus I expect shale producers will be unable to withstand prolonged periods of lower oil prices.
Oil supply will soon be progressively be withdrawn from the market, and the oil price will likely appreciate. The share prices of major integrated oil producers will rise and these companies will have the opportunity to significantly repair balance sheets. At that time, investors who have held through the cycle and reinvested dividends will see substantially higher dividend income from their increased share count.
In my opinion, the play for long term total return and higher dividend income from oil companies hasn't changed. It requires holding through a full cycle, getting the benefit of dividends during bearish conditions, reinvesting these dividends back when share prices are low, and then reaping the rewards as prices rebound.
The identification and investment in high quality franchises that can maintain dividends through the cycle is still as important as ever. Recent events seem to suggest the importance of holding major oil firms that have both upstream and downstream operations and not upstream operations alone or downstream operations alone. It for this reason that I'm determined to continue my quarterly investment in Exxon as one of my 30 stocks for 30 years.
Disclosure: I am/we are long XOM, BP, COP.
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.