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Oil Majors: Dividend Investing Amid The Downturn

The four oil majors are well positioned to continue paying dividends as price environment gradually improves to $60-$70 a barrel over the next few years.

But in the worst-case scenario, as warned by Goldman Sachs, all best will be off.

Income seeking investors who prefer safety of dividends should look towards refiners, such as Valero.

The leading oil producers have offered some of the highest and most reliable dividends over the last several years. Following the slump in oil prices, these dividends are looking even more attractive. The European vertically integrated energy companies BP (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.A) are offering yields of almost 8% while their U.S. based peers Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) promise yields of 4% and 5% respectively. On average, the stock of these four of the world's biggest oil and gas producers come with a record yield of 6.3%, significantly higher than the S&P-500 average yield of close to 2%.

On paper, these four companies are well positioned to continue paying dividends as oil price environment gradually improves to $60-$70 a barrel over the next few years. Although these companies have reported significant drops in operating cash flows due to lower realizations, they have made wholesale cuts to their capital budgets to bring their spending levels closer to cash flows.

In the second quarter, for instance, on an average, Exxon Mobil, Chevron, BP and Shell reported 30% lower cash flows from last year as realizations dropped by 40% to around $43 per boe. But the producers also made double-digit cuts to their capital budgets. In the second quarter, these four companies slashed their capital expenditure by an average of 17% on a year-over-year basis, with Shell reporting the biggest cut of 21% and Chevron the smallest of 14%.

According to estimates from a Sep. report emailed to me from Oppenheimer's Fadel Gheit, on an average, these four companies could report 33% decline in cash flows this year, led by 41% drop at BP, 34% at Chevron, 30% at Exxon Mobil and 29% at Shell. But they will also likely reduce their capital spending. Gheit sees the two European majors reducing their budgets by 19% each while Chevron and Exxon Mobil will cut their spending by 17% and 11% respectively.

Besides, Exxon Mobil, Chevron, BP and Shell have shown through various measures that conservation of cash and dividend yield is their top priority in the downturn. Exxon Mobil has recently agreed to sell its troubled Torrance refinery for $537 million which will beef up its already strong balance sheet. Chevron is eyeing cash flow neutrality within a couple of years as some of its major projects, including Gorgon and Wheatstone, come online. BP has planned to shed assets worth $10 billion which should improve its financial health. Shell has halted its expensive Arctic drilling efforts that have so far cost $7 billion.

However, these companies have been outspending their cash flows. As a result, dividends are being funded through additional borrowings. However, that's not alarming since the four majors have stellar balance sheets which can easily absorb more debt. At the end of the second quarter, the net debt ratio of the majors averaged just 14%, significantly lower than the average of close to 25% of large cap majors, independents and refiners. Exxon Mobil, in particular, has more financial resources than any other oil producer, thanks to the ownership of 3.8 billion treasury shares worth $238 billion.

If oil recovers slower than expected, then I believe the majors will make another round of wholesale cuts to capital budgets, sell assets, reduce costs, eliminate jobs and increase focus on more promising downstream and other non-E&P businesses to protect shareholder returns.

But what if oil does not recover at all? What if Goldman Sachs' seemingly worst-case scenario of oil dropping to as low as $20 per barrel and the cheap pricing environment to persist for 15 years actually materializes? In that case, all bets will be off.

Although the current debt-powered dividend strategy is not looking threatening, it is not sustainable in the long-run, especially if oil fails to recover to $70 a barrel in the foreseeable future. Further weakness in oil prices would force the majors to rethink their payout strategies. The risk of a dividend cut, or even a suspension, which would be a last resort move, would substantially increase.

In short, the juicy average yield of 6.3% from Exxon Mobil, Chevron, BP and Shell is looking safe, but it's certainly not the safest. I believe that those income seeking investors who prefer safety of dividends over fat yields should look towards refiners rather than the four integrated majors.

The independent refiners don't offer much in terms of yield, with an average of just 2.6%. But these companies have been the sole bright spot in the energy patch in the downturn, thanks to the cheap oil prices which has lowered the input cost and strong demand of gasoline.

The stark contrast between the performance of the oil majors and refiners was evident in the second quarter. At a time when oil majors incurred significant decline in earnings and revenues, the big refiners Valero (NYSE:VLO), Tesoro (NYSE:TSO), Marathon Petroleum (NYSE:MPC), Phillips 66 (NYSE:PSX) and HollyFrontier (NYSE:HFC) posted 68% increase in average earnings and 51% increase in average cash flows from the second quarter of last year. Meanwhile, the refiners posted more than 40% increase in their respective capital expenditures from a year earlier. Moreover, with the exception of Phillips 66, which is the least pure play refiner as compared to its peers, the refiners have been reporting positive free cash flows.

For oil producers, a quick rebound in oil prices is looking highly unlikely. The tough pricing environment could persist, and in the worst case scenario, this could make it difficult for the oil majors to maintain the lofty dividends. But that's good news for refiners who will continue to enjoy the benefits of cheap oil. And since most of the dividends in the refining space are coming from internally generated cash flows, the refiners are the safest stocks for income seeking energy investors.

My top pick among the refiners is Valero. The company currently offers a yield of 2.7%, slightly higher than its peer average, but it is the biggest publicly traded independent refiner in the world, exhibits one of the best free cash flow profiles and has been focusing on rewarding the shareholders through dividends and buybacks. The company generates more free cash flows than any other refiner and has the highest free cash flow yield in its peer group. On top of this, Valero is the cheapest refining stock in terms forward (2015, 2016) EV/EBITDA multiple, as per data compiled by Thomson Reuters.