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Large Oil Company Dividends Might Not Be Sustainable Long Term


Large oil companies are commonly held in the portfolios of dividend investors because of their long history of stability.

Due to the decline in oil prices, none of the “supermajors” are able to pay their dividends out of cash flow.

These companies are therefore resorting to other and ultimately unsustainable methods to pay their dividends.

The low rate environment has allowed many companies to take on debt to pay a dividend, but this will not last forever and there are limits to this strategy.

Companies have also been selling assets – ultimately liquidating themselves, which is certainly unsustainable.

One of the primary reasons to invest in dividend-paying stocks is to generate income. This is particularly important for those individuals who are living off of their portfolios, such as retirees. As a result, those investors that are in this category are almost certainly going to be concerned with the ability of the companies that they are invested in to sustain their dividends over extended periods of time. In this article, we will examine the dividends of a very popular investment among dividend-focused investors – large oil companies – and determine how sustainable their dividends truly are.

While most investors focus on a company’s earnings to determine whether or not a firm can afford its dividend, ultimately a company’s ability to maintain its dividend depends on its ability to generate cash. This is why a wise investor will always look at a company’s statement of cash flows in addition to its income statement when evaluating a company’s suitability as an investment. In particular, an investor should consider the company’s free cash flow. Investopedia defines free cash flow as:

… a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.

Among the opportunities that enhance shareholder value referenced by the above definition is the payment of dividends. In short, a company needs to bring in enough cash after its capital expenditures to pay its dividend in order for the dividend to be sustainable on a long-term basis. Unfortunately, many of the world’s largest oil companies, many of whom are considered to be dividend stalwarts, are currently not generating enough free cash flow to afford their dividends. This is illustrated in this table:

Company Exxon Mobil (NYSE:XOM) Chevron (NYSE:CVX) Royal Dutch Shell (NYSE:RDS.A) BP (NYSE:BP) Total (NYSE:TOT) Eni (NYSE:E)
Operating Cash Flow $30,344,000 $19,456,000 $29,810,000 $19,133,000 $19,946,000 $12,930,000
Capital Expenditures ($26,490,000) ($29,504,000) ($26,131,000) ($18,648,000) ($25,132,000) ($11,535,000)
Free Cash Flow $3,854,000 ($10,048,000) $3,679,000 $485,000 ($5,186,000) $1,395,000
Dividends Paid ($12,260,000) ($8,120,000) ($9,847,000) ($6,750,000) ($2,945,000) ($3,778,000)
Deficit ($8,406,000) ($18,168,000) ($5,808,000) ($6,265,000) ($8,131,000) ($2,383,000)

(all figures in thousands)

Source: Yahoo Finance, Company Filings

As this chart shows, the largest oil companies in the world, without exception, failed to generate enough cash in 2015 from their normal operations to pay the dividends to shareholders that they actually paid. Granted, one of the reasons for this is that the low oil price environment has severely strained the cash flows of nearly all oil companies around the world and the supermajors are no exception. However, some of these companies, such as Exxon Mobil and Chevron, were returning more money to shareholders than their respective businesses actually generated even when oil prices were much higher. I discussed this herehere, and here.

This should certainly be a concerning situation for shareholders in these companies. After all, if they are unable to generate enough cash to completely cover the money that they are paying to shareholders then how can they sustain these payments? The short answer is that they cannot, at least not on a permanent basis. In general, there are two ways that a company in this situation can obtain the money that it needs to pay its dividend. The first option is that the company can borrow money. This is a particularly appealing option to companies in both the oil and other industries today given the low interest rate environment present across much of the world. Companies such as Exxon Mobil, which have very low debt loads, are prime candidates for maintaining their dividends in this way. Ultimately, however, no company can use this method to maintain its dividend indefinitely as it will eventually amass more debt than it can carry.

The most common way to determine a company’s relative debt load is to use a metric known as the debt-to-equity ratio. Investopedia defines this metric as:

… a debt ratio used to measure a company’s financial leverage, calculated by dividing a company’s total liabilities by its stockholders’ equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in stockholders’ equity.

The question investors in any of these companies must ask themselves is how much debt their company can carry. One way to approximate this figure is to do a peer comparison. In short, this process assumes that a company can carry a debt-to-equity ratio approximately equivalent to its most highly levered peer. Therefore, here are the debt-to-equity ratios of the same large oil companies:

Source: Yahoo Finance, Company Filings

As this chart shows, the two American supermajors have substantially lower leverage than their European counterparts. This is a very good sign for investors in both of these companies, including dividend-focused investors, as it means that both companies should have a much greater ability than their European peers, particularly BP and Total, to take on additional debt in order to finance deficits in their cash flows. With that said however, this is certainly not a long-term solution and even these dividend aristocrats may have to cut their dividends should oil prices remain at their present levels for an extended period.

There is another risk to using this strategy in order to maintain payouts to shareholders. That risk is that interest rates may rise and thus increase a company’s financing costs. While for the past several years, interest rates all over the world have been at or near all-time lows, thus making debt financing cheaper than ever before, there is no guarantee that this will always be the case. While I have long been skeptical of the forthcoming rate hikes that the market keeps predicted, even I have to admit that rates will increase eventually. Once this happens, those companies that took on debt to finance their dividends could find this strategy much more difficult to maintain, especially if oil prices remain low.

The second way in which a company that has a free cash flow lower than its dividend can pay the dividend is to raise money by selling assets. As this technique essentially amounts to a controlled liquidation, it is also ultimately unsustainable. This is also a particularly worrying way for an oil and gas company to raise money in the current environment as the decline in oil prices has reduced the value of their current assets, causing companies across the industry to take impairment charges against their earnings. Interestingly, Exxon Mobil has not yet taken such charges, prompting the New York Attorney General to launch an investigation into the oil giant’s accounting practices. Aside from the fact that by selling its assets, a company risks its ability to grow its cash flow going forward, the low oil price environment means that a company is essentially selling low, especially if it purchased its stake in a given field a few years ago at a higher price.

Ultimately, investors should not get complacent about the safety of the dividends paid out by any company in which they are invested. In the end, no company, in the oil business or any other, can continue to pay out or raise a dividend that is not supported by its free cash flow. It is up to every investor to truly look at where a company is getting its money.

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.