Exxon Makes Final Push to Protect Dividend; We Plan to Continue Holding Our Shares for Now
Exxon Mobil has finally drawn a line in the sand with its balance sheet. During its earnings call in late July, the company said it does not plan to take on additional debt during this oil market downturn.
Instead of borrowing more money to fund the dividend until oil prices improve, Exxon hopes to keep its payout safe by further slashing capital spending and operating costs.
"We can't know with certainty how the market will evolve from here. There's too many unknowns, of course. So you have to maintain a degree of flexibility to be able to respond should the recovery not play out as expected. But we feel very confident that we will be able to maintain that level of debt and maintain that dividend, certainly for the coming year or months."
– Senior Vice President Neil Chapman, Q2 Earnings Call
Exxon and its predecessors have paid uninterrupted dividends since 1882, a track record management wants to maintain since around 70% of Exxon's shareholders are retail investors who primarily own the stock for its dividend.
However, Exxon's 10% dividend yield indicates that investors aren't optimistic about the oil market recovering in time to avoid a dividend cut.
As we discussed in May, we continue to believe Exxon's dividend safety hinges on oil prices returning closer to their late 2019 levels ($50+ per barrel versus $40 today) by mid-2021.
Exxon's Borderline Safe Dividend Safety Score reflects moderate risk of a dividend cut, and we would likely downgrade Exxon's score if oil's recovery stalls.
We've owned shares of Exxon Mobil in our Conservative Retirees portfolio since July 2015 when we initiated a position at $79.29 per share.
During our holding period, Exxon has paid cumulative dividends of $16.77 per share, representing over 20% of our initial investment.
But the stock's abysmal performance this year has more than offset those dividends, resulting in an unrealized loss of about 35%. (Our Conservative Retirees portfolio returned 56% since inception in June 2015 through August 2020.)
Is now the time to bail on our Exxon investment? These are tough judgement calls to make, but we plan to continue holding based on our belief that Exxon's upside potential outweighs its downside risk at today's valuation.
After topping $100 per barrel in 2014, oil prices averaged less than $60 from 2015 through 2019. We believe that period still represents a reasonable "new normal" for the oil market once the pandemic's unique headwinds subside.
Using Exxon's average annual earnings from 2015 through 2019, the stock trades at a modest P/E ratio of about 10.
Exxon could continue sliding from here if the pandemic-induced recession turns out to be more severe and prolonged than the market expects, delaying a recovery in the oil market.
After all, the shock to energy demand in 2020 is already set to be the largest in 70 years, with a decline seven times greater than the 2009 financial crisis, per the International Energy Agency.
The U.S. accounts for around 20% of global oil demand (the most of any nation) and about half of that amount, or 10% of worldwide demand, is tied to U.S. gasoline consumption.
Therefore, the pace of America's economic recovery, especially in regards to road transportation, remains key to oil's short-term outlook.
In a lower-for-longer oil scenario that forces Exxon to cut its dividend, some retail investors may dump their shares.
But with so much bad news already in the stock price and presumably no incremental news impacting Exxon's long-term outlook, I'd be surprised if the selloff was severe.
Ultimately, the long-term outlook for oil and gas will drive Exxon's valuation.
Predicting the future of energy is not easy, as demonstrated by President Jimmy Carter's warning in 1977 that "the oil and natural gas we rely on for 75% of our energy are simply running out." (U.S. oil and gas production both hit record highs in 2019.)
That said, the next century seems unlikely to be as kind to fossil fuels as the last.
With the pandemic shifting work and travel patterns, causing global oil demand to fall about 10% this year, some energy giants such as BP believe energy demand will never recover to pre-COVID levels.
Other companies including ConocoPhillips and Exxon expect oil demand will return to 100 million bpd and continue growing from there.
All three of the world’s main oil forecasting agencies anticipate demand returning to 2019 levels as well, but not until 2022.
If we had to guess, the world's energy mix will remain diverse for the foreseeable future, with fossil fuels remaining a core component.
Over the last century, liquid fuels took the largest share of global energy supplies thanks to their widespread availability, affordability, ease of transportation, and ability to meet a variety of needs.
Source: Our World In Data
Outside of the world's 37 OECD countries, which consist mostly of developed markets such as the U.S., Japan, and Germany, those traits remain especially important.
Non-OECD countries, including China, India, and Brazil, accounted for 53% of global oil demand in 2019. Oil consumption across non-OECD countries has increased around 2% to 3% per year as their populations grow and their middle classes expand.
Oil demand in OECD countries (47% of global oil demand) has been shrinking around 0.5% annually thanks to improving fuel efficiency and their push for cleaner energy.
The pandemic may accelerate this pace of decline, but calling for an imminent death of fossil fuels seems like an extreme stance given the continued importance of oil to developing markets.
On September 24, ratings firm Standard & Poor's shared a similar perspective:
"COVID-19 has reduced long-term world oil demand by 2.5 million barrels per day. That decline is, however, not enough to substantively bring forward the year of peak oil demand that S&P Global Platts Analytics projects for the late 2030s. Under its sensitivity analysis, oil demand could peak in 2025 if policies and business and consumer behaviors change drastically, including near total adoption of working from home, reshoring of supply chains, widespread electrification of road transportation, and a halving of air traffic."
Meanwhile, global investment in future supply has collapsed. Upstream investment this year is projected to plunge to its lowest level since 2005. With oil reserves being depleted continuously, this could cause non-OPEC supply (about 60% of global output) to stagnate in the decade ahead and help rebalance the market.
Turning back to Exxon, we continue to believe the firm can weather a prolonged downturn, even if the worst-case scenario for the dividend plays out next year.
Exxon still maintains a solid AA credit rating and ended the second quarter with $12.6 billion of cash. The company historically carried less than $5 billion of cash, so Exxon maintains some cushion as it awaits a recovery.
The biggest unknown is how much Exxon can reduce its cash burn rate until oil prices recover. Dividends and capital spending are Exxon's uses of cash.
Exxon's dividend costs $14.9 billion per year, and management plans to reduce capital spending to an annualized run rate around $19 billion by the fourth quarter (down from $23 billion previously), with an even lower level targeted in 2021.
We'll assume those uses of cash total around $33 billion per year in this environment.
Without taking on more debt, Exxon must cover those obligations with operating cash flow, asset sales, and cash on hand until market conditions improve.
In first quarter of 2020, Exxon generated $7.2 billion of operating cash flow (excluding working capital changes), or about $28 billion annualized.
Oil prices averaged near $50 per barrel during the first quarter versus $40 today, but Exxon's downstream and chemical businesses, which historically accounted for 50% of earnings, also operated at a loss as pricing and margins remained near cycle lows.
Going forward, perhaps Exxon's operating cash flow will sit somewhat below that range, representing an annual run rate of around $22 billion to $25 billion (below its level in the 2009 financial crisis and about in line with the 2016 oil crash).
To continue closing the gap, management expects to reduce annual cash operating expenses by at least 15%. If successful, we estimate this will save around $7 billion per year, putting Exxon close to achieving cash flow neutrality even with its large dividend.
Asset sales could also add $1 billion or so to Exxon's cash buffer despite today's challenging backdrop for energy assets.
With a little squinting, you can see how Exxon has a path to maintaining its dividend for at least a couple more quarters so long as oil demand continues showing signs of improvement.
As an income investor, it's hard not to appreciate management's dedication to the dividend given the current environment.
Exxon can't wait forever if the economic recovery stalls, though. Cutting the dividend would restore the company to a positive free cash flow position, providing flexibility to restore the balance sheet, invest more for the future, and consider acquisitions.
No one knows what the next year will hold for the energy market. But at Exxon's current valuation, plus my expectations for fossil fuels to remain a core component of the world's energy mix, we're willing to continue holding our shares to see how the future unfolds before considering other ideas.
