As most of you are aware, oil prices have decreased significantly since hitting a high in June 2014. This has reduced earnings projections for energy companies, and therefore depressed share prices. The question on the minds of many dividend investors is what to do in this situation. I generally operate under the belief that the upside will take care of itself, meaning that if prices rebound, earnings will go up and dividends will continue growing as well. This is why in this article, I will focus mostly on risks, and how to mitigate their potential impact. I will also discuss how I plan to deal with this situation.
The goal of a dividend investor is not how much a company can earn today, but whether it can earn more over time. Oil companies earn more by finding and producing more oil, or if prices they sell at increase over time. Before we dig further, there are several risks which are discussed, concerning energy companies these days. I will address those below.
The first risk is that demand for oil and gas will be drastically less in 20 – 30 years due to it being replaced by by green energy sources such as wind and solar. The first risk is mitigated by the fact that renewal energy sources are intermittent, which means that there will always be a need for fossil fuels. The risk is also mitigated by the fact that our modern economy is based on oil, as this is the base for things like plastics, pharmaceuticals and hundreds of other things. The risk is also mitigated by the fact that it would take a tremendous amount of time, and investment in infrastructure before renewable energy sources replace significant energy needs of society. This means infrastructure, as well as retrofitting machinery needed for the energy available. For example, most cars these days run on oil and some run on natural gas. Very few cars run on electricity alone. In order for all cars to run on fuel that is not gasoline, but something else, we need time, money and effort to build out refueling stations, replace millions of existing cars and not make any more new cars that run on traditional fuels.
Another risk that somewhat goes along with this first one is the notion that oil and gas companies will somehow end up with reserves in the ground, which they won't be able to tap because of concerns related to greenhouse gases. I agree that global warming is an issue, and that the world needs to be more effective in doing so. However, I find it very difficult to believe that the world will stop using conventional energy sources within the next 20 years. The technology might be here to harness power of sun and wind, but the technology to store energy is not here. Plus again, it would take a tremendous amount of time, investment and dedication from ALL countries to make the switch. I would say the next 20 years would be fine for energy companies. I also find it hard to believe that all countries in the world will act together for the long-term benefit of everyone, while foregoing their short-term economic and policy needs. Hence, I am going to bet my money that the next 20 years will be good for energy companies. Plus, it would be very helpful to stock pickers like me, when large investors decline to invest in companies despite their excellent value and growth prospects, merely because of a "moral objection". Less competition and demand means better prospects for better long-term returns. Just check how that worked out for those who stuck with Altria/Phillip Morris investors over the past 50 years. ( Hint: It compounded at almost 20%/year)
The other risk is that with much fuel efficiency out there that oil demand further decreases over time. The second risk is mitigated by the fact that energy use will increase, as global economies keeps expanding, and as hundreds of millions of people join the middle class over the next 20 – 30 years. As poor countries become less poor, they will need to manufacture more goods and deliver more services, which should only increase demand for energy. Thus, I would expect worldwide energy needs to increase over time.
The other risk is due to oversupply we are facing today. You have governments such as Russia, Venezuela whose major exports is crude. If prices go down, they need to sell more in order to maintain revenues from falling. This further depreciates prices. When your main export is a commodity, your budget is under a lot of pressure to keep selling even more, especially if the price of that commodity drops a lot quickly.
You also have so much in unconventional oil and gas now, particularly in the US, which further decreases US demand for foreign oil. This is because there is more supply of US oil and gas. This depresses prices. However, many of the unconventional oil and gas is only economical to produce at higher prices for the commodity. In addition, if prices for oil and gas stay low for longer periods of time, companies like ExxonMobil (XOM), Royal Dutch (RDS.B), ConocoPhillips (COP), Total (TOT), Chevron (CVX) will slash their E&P budgets, since would not be economically viable to produce oil and those lower prices for the commodity. This would be a self-correcting mechanism, which will ensure that supply of oil drops below a certain price. Therefore, a low price is a self-correcting mechanism which reduces supply from higher cost producers and also reduces the incentives to invest in more fields that will bring more supply a few years into the future. The problem of course is that this process takes a few years to work itself out.
Those risk items I am discussing of course represent longer-term risks affecting oil and gas, not fluctuations in oil and gas prices that are temporary in nature. That means the risks I describe are risks that oil and gas prices will stay down because of those risks, because demand has decreased or supply increased. Prices will always fluctuate due to supply/demand, and could just as easily rebound next year as they are likely to keep falling further south in 2015. Nobody can accurately predict commodity prices consistently, which is why it is important to look at the idea of investing in energy companies from the attitude that requires attractive entry prices and margin of safety in price and time.
Oil Prices are volatile, and could go easily to $35 or $105 easily through end of 2015. However, it is also important to not get too focused on short-term fluctuations, and end up missing the forest for the trees. What I am trying to say is that this current decline in oil prices is not the end of the world. Oil companies do not sell all of their oil at once, but almost ratably every month - hence for 2014, most oil has already been sold at higher prices. Because the oil price pendulum swings both ways, it is important to focus on average prices per month, over the course of an year to smooth out volatility. In addition, a portion of oil and gas is hedged. Furthermore, energy companies do not just sell oil, but they also sell natural gas, the prices of which have done pretty well this year. Also, if you look at oil futures prices over the next decade, you can see prices increasing by 3-4%/year. An oil executive could simply hedge their whole production over the next 10 years, and not have to worry about fluctuations. However, would you rather have all production hedged out, and expect smooth returns, while potentially missing out if prices really do better than 3-4%/year? Thus investors should not be scared by lumpy results - as the pendulum swings both ways. While EPS is not going to be as smooth as that for a Brown-Forman (BF.B), patient investors with long-term horizons could be pretty well compensated for the risks they took 15 - 20 years ago.
In another article, I discussed how not all P/E ratios are created equal. Because oil companies are cyclicals who explore for and produce oil and gas, they are price takers. This is because oil is a commodity, that sells on a global scale and is virtually not differentiated ( yes there are differences in type, such as heavy, sweet etc, but one cannot demand premium price for those if needed). Thus, their EPS and revenues are going to be volatile than revenues for Procter & Gamble (PG), Johnson & Johnson (JNJ) or PepsiCo (PEP). Hence, investors should not have taken the Low P/E’s at face value, but should have done their own independent assessments and stress test what earnings per share should be under variety of scenarios.
The point is that an investor buying energy companies today should not throw caution out the window. One needs to always maintain a risk-averse attitude, which would enable them to continue investing, even if they are temporarily wrong.
The first line in defense is to own energy companies in the context of a diversified dividend growth portfolio.
The second line of defense is the type of energy companies to own. For example, there are some energy companies such as pipelines, that are not dependent on prices of oil and gas. Those are dependent on volume of oil and gas transported throughout their vast network. The volume are generally stable and not volatile like the prices of underlying commodities. Many of these could be temporarily knocked down by program selling where some heavy hitter wants to get out of “energy” exposure and thus indiscriminately selling everything, pipelines included.
The third line of defense is to acquire positions in those energy companies which have managed to increase and maintain dividends for several decades. If a company has managed to maintain dividend payments and even increase them in the 1980s or 1990s, when energy prices were mostly flat, they get gold stars in my book. Those companies include majors like Exxon Mobil (XOM), Chevron (CVX), and ConocoPhillips (COP). Companies that are facing some weaknesses today, might be in a tougher positions, since lower prices are putting an extra squeeze on the situation. This is why quality blue chip energy companies, with demonstrated staying power in earnings and dividends during previous difficult times for oil and gas prices is important.
The fourth line of defense is acquiring stakes in those energy companies slowly, in case one does not get the timing right. I always like to give myself some room for error, in case I am wrong, when I am building out a position in a company. For example, if energy prices keep sliding from here, many energy companies might not only have to report much lower earnings, but they might also have to have big one-time impairment expenses. Writing down assets is one of the major reason why ConocoPhillips lost money in the fourth quarter of 2008. The last but not least line of defense is to focus on companies that offer a sustainable dividend payout ratio. Exxon Mobil (XOM), Chevron (CVX), and ConocoPhillips (COP). have sustainable dividend payout ratios today. I believe that dividends per share will be maintained, even if earnings dropped by half in 2015.
Tomorrow I will continue the discussion on whether energy stock values represent a good opportunity for investment. I will discuss the investments I am considering in this environment, and dig into more detail behind each company. Stay tuned for another article tomorrow.
Full Disclosure: Long COP, XOM, CVX, RDS/B, BP, PEP, JNJ, PG, BF.B,
- How to Generate Energy Dividends Despite the Peak Oil Non Sense
- Why Warren Buffett purchased Exxon Mobil stock?
- Dividend Investors Should Ignore Price Fluctuations
- The predictive value of rising dividends
- You don’t need to be right all the time to succeed with dividend investing
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