Movers and SHAKERS
Dividends and the Appeal of Energy Stocks
Energy stocks have had a tough 2020. The Energy Select Sector SPDR (XLE) is down 46% in 2020 versus a 5% increase in the S&P 500 Composite Index. The decline has meant that many energy stocks now offer dividend yields above 5%, an attractive rate compared to low bond yields. Energy stocks have always been a volatile group subject to the cyclicality associated with energy price booms and busts. Clearly, we are in the middle of a bust cycle with West Texas Intermediate (WTI) oil prices having fallen 40% year to date. The cure to a bust cycle comes when producers stop drilling so that supply and demand realign, and energy prices rise. For energy companies able to withstand short-term cash flow issues, management will often maintain existing dividend levels in anticipation of improving cash flow. That seems to be the case for energy companies like Chevron and Exxon Mobil, which have maintained their dividend and currently have dividend yields of 6% and 9%, respectively. Other energy companies such as Royal Dutch Shell and BP Amoco have decided to cut their dividend and put that capital into developing renewable assets and other non-energy investments.
The different paths taken by the major oil companies has profound implications for investors. If the drop in energy prices is part of a normal boom/bust cycle created over drilling, high-dividend-yielding energy stocks are attractive investments. Many of the high-yield energy companies have ample liquidity and strong balance sheets that will allow them to maintain dividend levels for many years of low energy prices. The high yield, combined with the prospect of a rising stock price associated with the end of the bust cycle, could provide investors with large total returns. If, on the other hand, lower energy prices reflect a fundamental shift in oil prices, these stocks may ultimately be forced to throw in the towel and cut the dividend. Those companies will be behind their competitors in shifting their attention towards other investments.
The case for energy stocks
- Supply is responding. Drilling in the United States, which is the largest producer of oil, has screeched to a halt. Baker Hughes reports that there were 254 rigs drilling in the United States as of September 11, 2020. That is down from 886 rigs from a year ago. The Energy (EIA) reports that U.S. crude oil production is down to 10,000 barrels per day from a level of 13,000 BPD at the beginning of the year.
- Bankruptcies are increasing. Drilling that was lost due to companies reducing capital expenditures will return if oil prices improve. Drilling associated with companies that have declared bankruptcy will not return quickly. Haynes and Boone report a steady increase in the number of energy company bankruptcies since 2019 in response to lower energy prices.
- Demand will respond when the pandemic passes. Part of the loss of energy demand is associated with weak global economic conditions due to COVID – 19. As the spread of the virus abates through the development of a vaccine, it is reasonable to believe that the demand for oil will return.
- High returns can be made in a declining industry. Charles Sizemore, chief investment officer of Sizemore Capital Management, compared the industry to the tobacco industry of 20 to 30 years ago. Tobacco stocks provided strong returns to investors even as the industry shrank as the larger players maintained their dividends and acquired smaller players.
The case against energy stocks
- Demand is fundamentally changing. Unlike past energy price cycles, this bust cycle is being caused by a fundamental shift in consumer habits that do not favor oil. The growth in renewable energy has decreased the demand for oil to power generators. The growth in electric vehicles could represent a similar shift away from oil demand to produce gasoline. Business airline travel and daily commuting may never be the same as the world shifts towards video conferencing and away from in-person sales.
- Supply is fundamentally changing. The cost of producing oil has become less expensive due to technological improvements in drilling and extraction. OPEC and its allies realize that the shale boom in the United States will not go away at oil prices above $50/BBL and has increased production even though it knows that will drive oil prices lower. Saudi Arabia has shown a new willingness to punish its allies that do not comply with production reduction targets.
As is usually the case, the truth probably lies somewhere in the middle. There have been fundamental changes in both the supply and demand sides of the energy equation. At the same time, temporary, abnormal events have amplified the impact of fundamental changes on energy pricing. We anticipate improved oil prices but do not hold out much hope for a return to the days of oil prices above $60 per BBL.
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https://www.inquirer.com/business/dividends-yields-10-year-treasury-etf-vanguard-pimco-20200309.html, Erin Arvedlund, March 9, 2020
https://finance.yahoo.com/news/big-oil-goes-looking-career-040154761.html, Javier Blas, Bloomberg, September 14, 2020
https://money.usnews.com/investing/stock-market-news/slideshows/the-best-energy-stocks-to-buy-this-year, Ellen Chang, U.S. News, August 4, 2020
https://www.haynesboone.com/-/media/Files/Energy_Bankruptcy_Reports/Oil_Patch_Bankruptcy_Monitor, Haynes and Boone, August 31, 2020