Stocks Investment

Don’t Let Oil Stocks Ruin Your Retirement

I have to admit, I do not enjoy writing these bearish articles. I know, heading into them, that I will receive criticism, pushback, and worse, from my readers who disagree. But, that’s okay. I’ll be the first to say that I am not a soothsayer and the difference in opinions is what makes a market. Honestly, I’d much rather spend my time researching potential purchases and writing bullish articles about high conviction picks. But, the fact of the matter is, the broad market has risen back to within 1% of all-time highs and this rally comes at a time when the underlying fundamentals are deteriorating. With that in mind, I don’t have many high conviction buys these days.

To me, there seems to be a clear disconnect between the broad market averages and the fundamentals that are supposed to support their valuations. The rally appears to be based off of high expectations for a quick bounce back from the COVID-19 crisis in the near future. Maybe that will happen. Maybe it won’t. But, either way, when I look at the majority of the stocks on my watch list, they appear to be trading on earnings expectations several years down the road and this level of speculation creates a dangerous situation for my fresh capital. And, while there are certainly still a handful of beaten-down sectors/industries in the market, for the most part, I’m of the belief, at this point in time, that much of what is cheap is cheap for good reason and investors should be very wary of bottom-fishing. This notion is what inspired this article.

Lately, I’ve seen many conservative, value-oriented, dividend-growth investors looking at the oil space because of the low valuations and the high yields available. Generally speaking, I think that’s the right mindset. We should be looking for irrational discounts in what is an otherwise irrationally expensive market. But, I don’t think we should ignore significant factors that caused such discounts, especially when they come in the form of secular headwinds.

The oil patch has been an underperforming industry for years now. However, up until recently, investors still had high dividend yields to fall back onto. That has changed in 2020 and I fear for income-oriented investors who continue to pile resources into this out of favor area of the market.

There is certainly something to be said about the idea of “buying low.” As a value investor myself, I’ve made a lot of money by waiting for weakness in the market and buying equities with wide margins of safety. However, it’s important to note that price is what you pay and value is what you get. A price decline does not necessarily mean that a stock is any cheaper. On the contrary, when the underlying fundamentals are eroding before our eyes, it could actually end up meaning that shares are equally, if not more, expensive.

Knowingly buying stocks that are facing secular headwinds makes it difficult to generate profits over the long term. Sure, cheap valuations may result in multiple expansion (which is typically your friend). But, if this multiple expansion is being based upon a shrinking bottom line, then it doesn’t really matter, does it?

I’m all for diversification. I think it helps investors to avoid risk. However, I am not for diversification just for the sake of diversification. This oftentimes leads to di-worse-ification.

What’s more, as income-oriented investors, negative secular pressure on a company’s fundamentals will not only likely result in lower share prices, but also unsustainable dividend situations as well. We’ve already seen a handful of large, integrated oil stocks that were previously viewed by many as blue chips cut their dividends in 2020.

Occidental Petroleum (OXY) was probably the first big surprise cut that occurred during the COVID-19 environment. Coming into 2020, OXY was sitting on a 16-year annual dividend increase streak, but in March, OXY slashed its dividend from $0.79/share to $0.11/share. This was devastating news for many income-oriented investors with exposure to the oil/gas space. And, then just a couple of months later, in May, OXY slashed its dividend from that $0.11/share level to just $0.01/share.

To me, this speaks volumes about the damage that dividend cuts can cause to passive income streams. Oftentimes, I think dividend increase streaks hold management teams accountable to investor bases. However, once a cut happens, the loyalty to the remaining dividend is fragile. This is one of many reasons that a dividend cut is typically a sell-signal within my portfolio.

We saw a handful of smaller midstream and exploration players cut their payments early on in the COVID-19 market, but the next big name to fall was Helmerich & Payne (HP), which prior to its 65% cut announced in March, had a 47-year dividend increase streak.

It’s incredibly rare to see a dividend aristocrat fall off of the Dividend Champions List. Companies that have multi-decade-long dividend increase streaks have proven, throughout a wide variety of economic environments. They’ve proven the ability to compete, adapt, and evolve over time to continue to generate the reliable cash flows necessary to provide a sustainably growing dividend over time. More often than not, when near-dividend Kings begin to fall, it’s clear that there is major upheaval going on in the industry as a whole.

The HP cut is the most recent major U.S. oil/gas name to make a negative dividend announcement, but this aristocrat’s fall has been recently overshadowed by a couple of European oil majors making big dividend changes.

In late April, Royal Dutch Shell (RDS.A) (RDS.B) made major headwinds when it cut its dividend by 66%. This was the first time that Royal Dutch had cut its dividend since World War II. That’s an amazing statistic. Roughly 75 years of dividend sustainability gone due to the oil price wars we saw coincide with the demand drop associated with COVID-19. RDS posted a quarterly loss during their first quarter earnings report that inspired the cut. That figure was down from net income of roughly $6 during the same quarter one year ago.

When announcing its cut, analysts noted that it would save the company roughly $10b/year. Shell management mentioned that they were focused on investing more in renewable energy sources, whose growth has proven to be more reliable, due to the secular tailwinds behind them.

And, as it turns out, RDS isn’t the only European major that was forced to cut its dividend and has since made plans to invest heavily in the green energy arena. BP (BP) announced a 50% dividend cut in early August and management has since said that it hopes to use the cost savings to invest heavily in low-carbon energy sources.

In a recent CNBC interview, BP’s CEO Bernard Looney spoke of the integrated oil company transitioning into an integrated energy name. He hopes to invest $5b/year in low-carbon energy sources by the end of the decade. BP hopes to reach 50 gigawatts of renewable energy generation capabilities by 2030. And, during this same time-line, BP has plans to reduce its hydrocarbon generation by ~40%.

Now, some have called out these European CEOs for pandering to ESG critics rather than taking care of their shareholders. However, the fact of the matter is, oil has been in a “lower for longer” price range for the better half of the last decade at this point in time and these maneuvers may be necessary for the long-term survival of these big energy businesses.

It’s worth mentioning that this is all old news. I’m not exactly breaking a hot take here. However, even after all of these dividends cuts in the oil/gas space, I continue to see income-oriented investors pour into the last remaining bastions of dividend growth hope here, seemingly assuming, that it must be different for those two names.

In short, it’s my opinion that things are not (different, that is). The same secular headwinds and supply/demand problems remain in place. And, there are still significant risks.

I’m talking about Exxon Mobil (XOM) and Chevron (CVX). These are the two highest quality oil majors. I’ve said that for years and I think the fact that they’re still standing with regard to maintaining their current dividend speaks to that truth.

But, just because XOM and CVX have not cut their dividend yet, doesn’t mean they won’t be eventually forced to. The longer oil prices stay depressed, the more and more difficult it becomes for these names to pay their dividends while maintaining capex. Due to low cash flows, something has to give. Thus far, these names have been making moves to sustain their dividends, but at what long-term cost?

Both of these names have announced investments recently into alternative and sustainable energy sources. That’s where the growth is, so that’s great, right? Exxon recently said that low oil prices could essentially wipe 20% of the company’s oil reserves off of its books (accounting for roughly 4.5b barrels of crude). The company was forced to cut its drilling budget by roughly $10b. So yeah, I think looking for growth wherever it’s available in the energy space is a good decision for these struggling majors.

But, what isn’t great is the fact that we’ve seen them forced to cut capex. XOM has plans to cut capex by $10b in 2020 alone. Cutting capex to make shareholder returns is akin to robbing future growth prospects to make payments in the present. In other words, to me, this is not a sustainable plan of action.

An RBC analyst recently posted a note that highlighted the fact that XOM’s cash flows do not cover its dividend. Instead, the company is essentially forced to raise debt to maintain its dividend aristocrat status. XOM bulls will argue that this is a short-term phenomenon; however, when I look at the deterioration of XOM’s balance sheet over the last 5 years or so, the trend looks rather systemic to me.

Earlier in the year, I wrote an article saying that I thought XOM would be forced to cut its dividend. Thus far, that thesis hasn’t proven correct. But, XOM’s cash pile is dwindling and the company’s long-term debt is nearing $50b. XOM’s long-term debt was only $18.7b or so in 2015, meaning that the leverage on the company’s balance sheet has more than doubled during the last 5 years. This debt increase comes during a period of time when net income and cash flows have been slashed as well. Eventually, this rising debt load will weigh too heavily on this well-known name.

And most recently, we saw news that XOM has plans to suspend contributions to its employee retirement plans starting in October. When cash flow struggles start to hit employee bases like this, the next step is oftentimes a loss of talent. We’ve seen brain drains occur in other struggling companies in industries that are experiencing disruption and anytime that I see things like the loss of benefits, pay cuts, or layoffs, I begin to worry about future growth prospects.

Thus far, I’ve focused on XOM. Truth be told, XOM appears to be in a worse situation than CVX; however, from an operational standpoint, CVX isn’t winning many awards either. In Q2, CVX produced a GAAP loss of $8.27b, compared to more than $4b in profits the year before. CVX’s balance sheet has seen deterioration in recent years as well, but not to the extent that XOM’s has.

So, while there are still some of these “blue chips” that have not cut their dividends yet, their fundamental growth outlook is certainly not painting a pretty picture. While the first dominoes to fall in the oil space in 2020 were the weaker names, I think the myriad of dividend cuts that we’ve seen in the oil/gas space this year is a harbinger of things to come for even the most defensive names in the space.

Simply put, the supply/demand metrics in the oil market are not attractive enough to generate higher prices. And, low prices on oil barrels mean fewer sales, lower margins, less cash flows, and ultimately, higher payout ratios. Companies can take measures in the short term to protect shareholder dividends, but these are just Band-Aids, not solutions. And, with that in mind, I think it’s in income-oriented investors’ best interests (especially if you are relying on dividend income to fund your lifestyle in retirement) to play it safe and avoid the apparent bargains in the oil/gas space. To me, the risk of further dividend cuts is simply not worth the reward of a short-term rebound.

Analysts are beginning to question the economic feasibility of a large portion of oil/gas assets. And, while it’s true that the big oil and gas names are pivoting towards the growth that is available in renewable energy markets, it’s still uncertain as to whether or not these shifts towards a green energy focus will be able to generate enough cash flows to sustain large shareholder dividends any time soon.

Without a doubt, the energy space is evolving in front of our eyes. And, while I believe this is a positive change for mankind and the planet as a whole, I do not necessarily believe that it means big oil, or big-green energy, or whatever hybrid mixture these well-known dividend payers morph into, will be an attractive place for income-oriented investors to look for reliable yields in the foreseeable future.

A dividend yield is only as good as its safety. As you can see when looking at the price charts of the oil stocks that have cut their dividends in recent months, the market does not usually take a favorable view of these moves. And, if you’re in retirement, this likely means a significant (if not permanent) loss of capital if you’re forced to sell because of passive income reasons due to the fact that it’s unlikely that you’ll have the time required to make up for such large losses in the market moving forward.

So, with all of this in mind, it’s my belief that income-oriented investors should be wary of high yields that they see in the energy space. The market is a big place. There are many, high-quality companies that operate in sectors and industries that are not facing such stark secular headwinds. So, why force yourself to own shares of companies that are facing such significant threats?

While acceptable yields and attractive value may be few and far between in these areas of the market right now, I think that a patient approach to investing and waiting to buy quality at fair or better valuations, rather than settling for more speculative yields backed by questionable fundamentals, is a prudent course of action.

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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.

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