While being undoubtedly exposed to the whims of the price of oil, Big Oil -- which includes Exxon Mobil (XOM), Chevron (CVX), Shell (RDS.A), Total (TOT), and BP (BP) -- seems to have a special place in investors' portfolios. That is mostly based on the companies' perceived ability to live through the lean days (or years, for that matter), using their accumulated wealth when the price of oil was much higher. The logic in favor of including these companies in one's portfolio is quite straightforward:
- Expecting a recovery in the price of oil -- that is somewhat well-founded in the medium term, as I've pointed out in my previous article.
- While you wait, you collect some fat dividend checks -- Big Oil surely can afford it.
So, can they really afford it? That is what I would like to figure out by comparing the reports of these major oil companies.
From a cash flow standpoint, the essence of the oil conglomerate business is pretty easy to describe:
A) A company gets its CFO from the products it sells.
B) It pays for the ongoing capex (CFI) to keep the capital-intensive business going.
C) It pays dividends to its shareholders to keep the stock valuation high.
If "A minus B minus C" is positive, that's great -- the company can increase capex and keep the business growing. Or, it could increase payments to shareholders and keep the valuation growing. Either way, it's a "winner's dilemma."
Now, things get really interesting, if "A minus B minus C" is negative -- as has been the case with Big Oil for a while now:
Obviously, the beginning of all the problems is the "A" part of the story. Due to a lower oil price and despite the cost-cutting efforts, CFO has dropped significantly for many companies -- in some cases, operating cash flow decreased by 50% (XOM) or even more (BP).
While the 2008-09 credit crunch was a relatively temporary affair for low oil prices, the post-2014 era is much longer. One must wonder how long these reserves of the good years will last before someone has to give something. To make my point as clear as possible, I will use a modified Kubler-Ross model and split the "adaptation process" into stages.
Denial (Late 2014-15)
Companies don't seem to have taken the major shift in the oil market seriously, so the initial reaction to the problem is pretty human -- ignore the change in trends and try to outlive it. The major evidence for that sort of activity is the ongoing net capex spending and lucrative dividend policies. That is accompanied by low CFO inflows, with the difference mostly financed by issuing new debt. The problem does not go away, of course, as is evidenced by the increased proportion of dividends in the companies' CFO:
The debt part of the story is truly outstanding. Big Oil has entered a post-crunch era, with relatively low levels of debt and thereby a vast credibility reserve to lean on in bad times. They did just that, as the industry went through its own debt binge to make ends meet:
Bargaining (2016 - Present)
To avoid the rapid expansion of the debt pile, the bargaining began. If you cannot do anything material about "A" (CFO) and are afraid of touching "C" (as dividend reduction would hurt the stock valuation), why not try selling some of the future's wealth and cut "B" (CFI/capex)? That's exactly how the industry reacted to the lower price of oil, and massive project cancellations started with the hope that these cuts will save the day.
However, it seems as if the aggressive cuts are simply not enough to balance the books even in the short run. Even after the belt-tightening on the CFO and CFI fronts, the "CFO minus CFI minus dividends" line is negative for most of the companies, so the need to borrow even more has not gone anywhere. As the debt stack increases, the third option -- a dividend cut -- could be evaluated sooner rather than later. If these prices stay (and they are only likely to drift toward a more or less rational range of $60-$70/bbl), Big Oil, along with the shareholders, will have to readjust to a new medium-term reality where the three-figure price of oil is not coming back. As a result, a healthy dividend cut to a sustainable level could follow.
How Much Time Do We Have?
To measure that, we could simply try to evaluate the increasing credit risk of Big Oil. One of the quickest ways to do that is to calculate the standard/trailing net debt/EBITDA ratio, which essentially compares the existing debt pile to the earnings in terms of years. The higher the figure, the riskier the issuer as it would take more years to repay all the debt. The radical shift in debt levels, unsurprisingly, happened in 2014 as the net debt/EBITDA ratios just skyrocketed from historically low levels.
In terms of credit ratings, we could conservatively state that the usual net debt/EBITDA level for the highest quality investment grade corporate issues is less than two. Net Debt/EBITDA between two and three could be described as a no-man's land. However, the ratio level of greater than three usually indicates that the company is facing some difficulties and could potentially be downgraded.
Judging from the 2016 data, only the mighty Exxon is still in the formal "investment grade" area (though it will take a radical shift in priorities for the company not to breach the net debt/EBITDA level of two soon). The rest of the gang is way above, with some companies' net debt/EBITDA sitting comfortably in the much riskier zone already.
The credit agencies have been somewhat lenient on Big Oil, but should the current direction of the companies' finances stay, room for this lax treatment is getting tight. As the "junk" status increases, the debt premiums required eat further into companies' financial stability, and I presume oil companies will strive to keep their "investment grade" status at all costs. As some weaker companies are already showing financial strain, we could expect a dividend cut (or a credit rating cut) to be getting closer by the day.
Would Higher Oil Save the Day?
What if a higher oil price is just around the corner? As I have previously found, the current spot oil prices are indeed unsustainable in a "bullish way" and should be ranging around $60-$70/bbl in the medium term. Following this logic, and bearing in mind that Big Oil stocks are competing for investors' money as well, it seems as if companies have all the right motivations to wait and hope for the best (steep oil price increases) soon. After all, a company that cuts its dividend just before the actual recovery in the price of oil would indeed have to suffer excessive damage to its reputation and share price -- for no benefit at all.
But is there anything worth waiting for here? Would the $60-$70/bbl range be sufficient to cover the ongoing Big Oil financial worries and end the "cut" talk? Let's do a gross comparison here, by comparing the "CFO minus CFI" lines of previous years to the actual dividend flow of the last year. This is gross approximation, of course, but at the very least it could help us to get a relative picture.
In this chart, we are considering two somewhat opposite scenarios -- the still-great year of 2014 with the average oil price of $96/bbl and the rather rubbish year of 2016 with the average oil price as low as $43/bbl. Judging from these figures only, one can argue that:
- Should the current prices stay, no single company can afford their current dividend policies, period;
- should the prices/cash flows of 2014 return Exxon would make it and, possibly, Shell/BP would make it, even though cash flows of the latter companies were swinging a lot due to one-off events; and
- even under the "2014" scenario, Chevron and Total could not afford their dividends.
Note that the oil price level ($96/bbl) for this optimistic 2014 scenario is way above the "rational" range of $60-$70/bbl -- no fundamental factors are present to push the price of oil that far, currently. For that reason, Big Oil is likely to be cash-draining even if oil recovers somewhat from the current low levels. Therefore, the value of waiting for a higher oil price is low, and adjusting the dividend level should be considered across the industry already.
Just to sum up what's been said above, it seems as if Big Oil has put itself in a rather weird position of being a dividend champion in the cyclical business than the oil market is. The third year in a row of low oil prices and ever-increasing dividends has strained the companies' finances and might lead to a debt downgrading soon. To avoid that, the companies should either get a three-figure oil price or cut the dividends. As a three-figure oil price remains a distant dream, the dividend cut seems to be a much more realistic alternative, which could help companies' finances adapt to the new market reality.
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.