Monday, August 10, 2015

Are these oil dividends safe?

The price of oil has declined a lot since the summer of 2014. The West Texas Intermediate (WTI) in Cushing, Oklahoma has declined from a high of $107.52/barrel in June 2014 to a low of $45.25/barrel in August 2015. This severe decline in prices has reduced the earnings power of many energy dividend growth stocks, which are engaged in exploration and production.

The question on everyone’s mind is whether these dividends are safe. Only after we answer this question, can we determine whether it makes sense to purchase those shares for income in a dividend growth portfolio.

Back in late 2014, I discussed whether the oil price decline was the opportunity of a lifetime. I talked about three companies I had my eye on. Initially, I discussed how I wanted to slowly build my positions every month. I even made a purchase of ConocoPhillips in early 2015, followed by a small purchase of Exxon Mobil (XOM) a few later. As I was buying Exxon Mobil, I had a change of heart after realizing that the oil price shock had drastically reduced energy companies’ earnings a few weeks later. Therefore, the drop in share prices was much lower than the decline in earnings power, which made those shares overvalued. As a result, I changed course and only recently bought shares in Exxon Mobil.

Somehow, the decrease in oil prices was like a slow motion train wreck. Everyone was watching oil prices stay low, yet the oil companies didn’t decrease in valuation as much. Somehow, many investors who were focusing on trailing 12 month earnings thought that oil stocks were a bargain. Since I look at past earnings and forward earnings expectations, I was waiting for lower prices. In other words, despite the decline in share prices, the earnings multiples didn't make much sense to be buying.

In retrospect, the fact that production volumes didn’t decrease when the price dropped should have been a warning sign. When you have a global market for a commodity, and a lot of countries depend on the sale of that commodity to keep the peace within their borders and feed their citizens, these countries have the incentive to pump out more in order to get more revenues ( or in this case – reduce the impact of lower prices by keeping production levels constant or trying to increase them).

My investment philosophy is based upon dividend growth, and safety of the dividend. This is why when I saw that ConocoPhillips (COP) and Chevron (CVX) were going to have drastically lower earnings, which provided inadequate dividend coverage, I put a halt to any purchases there. Of all the oil companies out there, Exxon Mobil (XOM) was and still is the only one which has adequate dividend coverage, and had a decent valuation.

2014 EPS
2015 EPS
2016 EPS
Dividend Payout

I went ahead and collected the data as of August 7, 2015 in the table above. I have prices, estimated earnings for 2015 and 2016, as well as 2014 earnings per share, and the prospective dividend payment per year. Then I calculated the P/E ratios based upon 2015 expected earnings. I also used the expected 2015 earnings to calculate the dividend payout ratios.

Unfortunately, its looks like ConocoPhillips (COP) and Chevron (CVX) dividends are not sustainable based on 2015 earnings per share. In the short term, oil companies can manage their cashflow by cutting exploration budgets, slashing labor costs, canceling share buybacks and taking on some debt. However, if oil prices recover over the next two years, the level of danger would decrease substantially. If oil prices do not recover however, it is quite possible that many dividends will be cut across the board.

Many companies such as ConocoPhillips (COP) are stating that the dividend safety is their number one priority. Somehow, this reminded me of the words of Jeffrey Immelt during the financial crisis in 2008 – 2009, who also constantly reassured investors that the General Electric dividend is safe. Well safe it was not, as GE cut its dividend in early 2009.

This also got me thinking about the parallels between the recent energy boom of 2010 – 2014 and the housing boom for the early 2000s. As we all know, the housing boom was followed by the Global Financial Crisis. Prior to the beginning of the crisis, the Chinese stock market had a bubble that had burst. We are seeing that these days as well. It took more than an year from the first signs of trouble in the second quarter of 2007 to the collapse of Lehman Brothers in September 2008. I remember during that time I believed that things are about to turn around, yet I was wrong. I have been thinking that things could turn around in eenrgy, yet there could be still more pain on the horizon with energy companies today.

The other thing I was thinking about is that in our connected world, the collapse in oil prices can have consequences in all sorts of ways and areas that you would otherwise not think about. I am wondering how will the weakness in energy prices spread to other sectors or countries. I would think that some weak drillers that sold debt would likely go bankrupt, though I have not seen a major high profile bust yet. For example, the Canadian banks could suffer, as their economy exports a lot of commodities. A drop in prices could mean less people being employed, less people able to afford ridiculously high housing prices and more loan writeoffs due to a softening economy. US Railroads have been punished, which creates some opportunities. The danger of course is that things could get much worse, before they get better. So while lower energy company prices could be an opportunity, it is also possible that they could be available at even lower prices down the road. The same could be said for quality financial companies in 2008, when many were available at cheap prices. However, several turned out to be value traps, as they disintegrated, while others like Wells Fargo or US Bank went much lower, before they rebounded. So while Wells Fargo might have looked like a bargain at $20, it was an even better bargain when Buffett was buying in the first quarter of 2009 in the high single digits.

I am also seeing weakness in pipelines, which is contrary to what I would expect, though it makes sense in retrospect. If there is less activity to drill for oil and gas, then there is less need for transporting that oil and gas, and lower need for future capital expansion. This leads to lower demand for transporting some oil on rails, which could also reduce short-term profits. I already own too much pipelines with Kinder Morgan (KMI), Williams Companies (WMB) and ONEOK Inc (OKE) however. If I didn't mind K-1 forms, Enterprise Product Partners (EPD) looks like a very decent holding as well.

So how do I plan to address all of this?

I plan on building out my position in Exxon Mobil (XOM), which I believe is the premier energy company in the world. Of all the companies out there, I believe this is the one that will survive the carnage. Just like I did with Target (TGT) last year, the plan is to slowly dollar cost average my way into Exxon Mobil. I cannot predict future direction of oil prices, which means that I need to have some dry powder ready if prices drop to ridiculously low levels. I believe that the oil industry is here to stay, since the modern world runs on oil. This means that I will be a buyer of Exxon Mobil at $75, $70, $65, $60, $55 etc. This is helped by the fact that I have cash coming in ready to invest every month.

I believe that Chevron (CVX) would be fine as well, though I would not be adding given the high forward payout ratio. The softening factor behind those two supermajors is that their operations are not limited to just exploring for and producing oil and natural gas. They also do refining, transportation etc. This softens the blow from lower energy prices a little. The one thing I am doing however is that I am automatically reinvesting dividends in my tax-deferred accounts into more Chevron stock. As usual, my taxable dividends are reinvested selectively.

The same couldn’t be said for ConocoPhillips (COP), whose dividend is likely in jeopardy, if the commodity prices do not rebound at some point in the near future. If ConocoPhillips cuts the dividend however, I would violate my sell rule and possibly keep on the shares, since they will probably sell at ridiculously low levels anyway. I am reinvesting my ConocoPhillips dividends in retirement accounts as well.

If oil prices recover some time next year, the best short-term performance will be generated by the companies that looked riskiest today. If oil prices stay stagnant, or decline from here, the most conservative companies like Exxon Mobil (XOM) will fare the best. Since I am in this game for long-term income that grows above the rate of inflation, I am fine missing out on a risky ten-bagger, if that means reducing the risk of a permanent capital impairment.

Full Disclosure: Long XOM, CVX, COP, KMI, WMB, OKE,

Relevant Articles:

The Energy Company I want to buy
Are Energy Stock Values Today a Once in a Lifetime Opportunity?
Are Energy Investments Today a Once in a Lifetime Opportunity (Part 2)
How to value dividend stocks

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