Follow up on my GMO post

My recent post (here) on energy companies has led to a lot of interesting responses from readers. One reader has forwarded research by JP Morgan showing that most oil companies they track cover their dividends at around a price of USD 50 per barrel and, therefore, my claim that the currently high dividend yield is unsustainable is wrong. (Interestingly, most commenters have focused on the dividend yield, ignoring my arguments about the other two valuation metrics employed by GMO – a sign of the times?).

Maybe a clarification is in order here to avoid misunderstandings. I never said that every oil company has to cut its dividend. My statement was about the (market-weighted) average that is used by GMO to construct the index referred to in the post. I have chosen Royal Dutch because I was of the opinion that given its 200 billion market cap and high dividend, it is to some extent representative and therefore a good example.

No doubt, there will be companies whose dividends are sustainable at the current price level. Obviously, this doesn’t mean it is true for the sector overall.

Lukoil, for instance, with which I am somewhat familiar due to my bond position (here), looks as if its high dividend yield is fine at current levels. But: Lukoil is exceptionally well positioned on the cost side. Not only is Lukoil a traditional low-cost producer (remember this chart), but it has enjoyed falling costs courtesy of a heavily depreciated Ruble exchange rate. I do not see how Royal Dutch, which sports a similar dividend yield as Lukoil, can match this cost advantage in the near future, even if they are likely to get concessions from suppliers. Either Lukoil’s dividend is supersafe, or Royal Dutch’s is not. I believe the latter. Remember: Lukoil’s dividend yield is high because of the famous Russia discount, not necessarily because of a general undervaluation of the sector.

Apart from that, the responses have triggered my interest and I have decided to have a quick look at the matter. As I do not have access to JP Morgen research, I have looked what Goldman has to say on this issue. In a recent research piece they had this chart,


The chart shows the current dividend yield and the oil price at which Goldman deems the dividend sustainable for the most important (in terms of market cap) players without resorting to debt financing and assuming that their capex estimate is sufficient to maintain production volumes (“organically”). Unsurprisingly, the lower the dividend yield, the lower the required oil price to maintain it. Also note that Royal Dutch needs an oil price of 63 USD – a mere 50 percent above current levels – to keep paying its high dividend over the long – term. The same is true for other major oil companies such as BP, Total, etc.

I would say this confirms my analysis.

The companies whose dividends Goldman thinks safe at current oil price levels, have yields of between 2.5 and 4.4 percent. That’s not bad, but if these yields excite you, I would urge you to have a look at “undiscovered” gems Microsoft (dividend yield: 2.75%) and Cisco (3.34%), both of which I own (here).

Ok, Royal Dutch is doomed, what about the others? Surely, they are good value at nice yields plus a “free option” should oil prices rise?

There is no denying that a 50 percent higher oil price would help – but that’s (bullish) forecasting. Let’s work with what we have and play around with Goldman’s analysis. Let’s focus on the term “organically”.

As explained before, organically in this context means that the capex estimate Goldman uses to estimate the sustainable dividend is high enough to keep current production volumes indefinitely by replenishing reserves 1:1. This is necessary if you are valuing the company as a mature dividend payer. In case Goldman’s capex estimate is too low, your option betting on a higher oil price is not “free”, but paid for by reducing the capital stock. Unfortunately, Goldman is a little unspecific on how they estimate their sustainable level, but they seem to be guided management.

So we have to work around the problem to see whether this is a good idea.

Exxon dominates the sector with its 350 billion market cap. Goldman think’s its yield at 3.5 percent sustainable at current prices. It is considered to be one of the better managed majors, free from the type of government meddling you get with European integrated oil companies. Warren Buffet was a major shareholder until recently calling it a “wonderful business”. In short, the best management.

Nevertheless, despite doubling their annual capex during the oil boom, their reserve replacement ratio has been below 100 percent, if one excludes their acquisition of shale gas play XTO in 2009. That’s according to Jim Chanos (here) who called the integrated oil companies value traps and liquidating trusts for this reason. I observe: even with record capex in the past they were not able to replace their reserves organically.

Now, at lower oil prices capex will have to fall. Who knows, maybe less cash at hand will help focus the mind of management, but it is a bet you have to be willing to make. Also new reserves will likely only come from politically unstable regions (such as Exxon’s Kashgan field in Kasachstan) a risk you also have to factor in. I feel that at current oil prices there is not much margin of safety to compensate for these risks. Cisco’s dividend is safer.

Further, over the weekend there has been an interesting development regarding Exxon mobile’s book value. From the FT (here),

(…) Last week, it emerged that Eric Schneiderman, New York attorney-general, was investigating Exxon’s decisions not to take large charges to its profits for writedowns in the values of its assets following the fall in oil prices. That move built on the probe he launched last year into the company’s statements on climate change.

The SEC is now also looking at Exxon’s reporting of its reserves, asset valuations and writedowns, as well as its disclosures on the risks that climate change creates for its business (…) 

Wow, the SEC is questioning Exxon’s asset valuation, i.e. its book value – although the stock price is trading near its all-time high and nobody has lost any money.

And for a good reason: Management at Exxon, you know the guys who have spent billions on capex when oil was at 100 without actually finding much, think that a halving of the oil price has no consequences for their book value. And what’s better: they seem to be the only ones.

I mean, even Royal Dutch has impaired their assets by USD 8 billion, or 4(!) percent of their asset value. The same goes for Chevron, which at least has reduced book values by USD 4.7 billion.

Message: do not trust these managements (and book values).


Clearly, the oil industry still believes that oil prices will recover significantly. As do many investors who either think the dividend yield is sustainable, or the optionality in case of a higher oil price is worth a lot. This view is embedded in the valuations and therefore this is not a contrarian play. The sector (average stock) is not cheap. Moreover, book value, one of value investor’s favourite metrics appears to be unreliable, just as it was in 2007/2008 with the banks. If oil prices do not recover substantially, we are going to find it out.


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