Amid recent oil market turmoil, energy companies are being forced to determine how they may weather the storm in the short term while staying mindful of how they are positioned for future growth. Research Analyst Noah Barrett explains why he believes an active approach and individual company analysis is particularly valuable in this disrupted environment.
- The COVID-19-induced demand shock and oil market-share war have driven oil prices to their lowest levels in nearly two decades.
- While the economic impacts and a timeline for recovery remain out of companies’ control, management teams are now faced with financial and operational choices about how they can weather the crisis and plan for the future.
- The energy sector as a whole has been affected, but it is clear that different companies are taking different approaches. The decisions firms make now, along with certain unique characteristics, may allow some companies to endure and emerge from a trying environment in a position of relative strength.
Energy markets already reeling from excess supply because of an oil market-share war between Saudi Arabia and Russia have been further burdened by a sharp downturn in global demand due to the COVID-19 coronavirus. As a result, oil prices have fallen below economically profitable levels for many energy firms. While we saw a return of coordinated supply cuts by the Organization of the Petroleum Exporting Countries (OPEC) and other cooperating countries (notably Russia), they are not enough to offset the magnitude of near-term demand destruction, and a meaningful recovery in oil prices looks to be a late 2021 event, at the earliest. Management teams are now being forced to take steps that may not only determine how they weather the storm in the short term but also how they are positioned for an eventual recovery.
Management’s Toolbox to Weather the Downturn
Given near-term volatility, we are seeing energy companies use different tactics to manage through the uncertainty and position for an eventual recovery. Share repurchase programs, popular during the previous bull market, have in many cases been put on hold, with companies opting to carry more cash on their balance sheets, prioritizing financial flexibility. Those with the capacity to take on debt have been turning to revolving loans and the credit markets to free up additional resources, given that funding is currently available and generally low cost.
Budgeting for capital expenditures (capex) – long-term investments that are key to future growth – we believe will have to be carefully balanced against near-term stagnation. While some investments may be outright canceled, many are at the very least being pushed back until a path to recovery becomes clearer. This seems reasonable given the current market environment, so long as there are not additional costs associated with the capex deferrals. Companies may increasingly look to fund large capex projects through joint ventures, sharing and reducing their financial burden with partners. Meanwhile, merger and acquisition activity, another option for growth, will likely decrease in the sector until there is more clarity.
Some companies have already chosen to defer tax payments under new legislation, such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act, to create short-term cash flow relief. Management may also exercise flexibility in a company’s dividend policy by choosing to suspend or reduce its dividends to save cash. Scrip dividends, by which a shareholder can choose to receive dividends in cash or in additional shares, can also provide a measure of financial leeway.
Dividend Policy: An Example of Divergence
Management teams have these and other tools at their disposal to weather the near-term slowdown. However, the paths they choose could potentially have longer-term impacts on companies’ financial stability and ability to grow once the sector recovers. A divergence in tactics can be seen in recent dividend policy decisions in the integrated oil and gas industry. As some of the largest, most recognizable companies in the energy sector, these businesses tend to have stable and growing dividends that are coveted by investors. Since none of these companies is organically covering its dividend at current crude oil prices and free cash flow levels, they are faced with difficult decisions.
For example, Royal Dutch Shell recently announced that it cut its dividend – a move typically made to save cash in the short term – for the first time since World War II. Notably, the company expects to keep the dividend at the reduced level rather than just reduce it for a quarter or two. This is because management sees recessionary trends in many of the markets and countries where Royal Dutch Shell operates and doesn’t see a recovery in oil prices or demand in the mid-term. As such, they would prefer to make a difficult decision – and suffer the market’s punishment – in the short term rather than face a potentially worse scenario (and market reaction) later.
At the same time, Chevron recently opted to maintain its dividend level. This is largely because it has one of the healthier balance sheets in the industry, with a lower net debt level than many of its peers. In this position of balance sheet strength, the company is able to fund its dividend, at least temporarily, through increased debt and reduced capex. It is certainly not a position that the company would like to pursue in the longer term, but it does give investors some comfort that the dividend is secure in the near term and that continued dividend coverage won’t materially impair the overall health of the company.
Analyzing Energy at the Company Level
While the energy sector overall has been punished recently, it is important to keep in mind that not all energy companies’ situations are the same. In addition to monitoring management teams’ actions, analyzing and identifying each company’s unique circumstances will be important going forward.
For example, companies with geographical exposures in the central Midwest of the United States, where stay-at-home restrictions have been less severe than in other parts of the country, have recently performed better than companies with other geographical exposures. Energy demand has been less impacted in these more rural areas, with their lack of mass transit, longer travel distances and higher agricultural usage. While this is a very short-term example, we continue to believe in the long-term importance of fundamental analysis, with a focus on companies with strong balance sheets and lower leverage that have the potential to survive this crisis and ultimately emerge in a position of strength. For this reason, we believe that an active approach and individual company analysis is particularly valuable in this environment.
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