With the price of oil dropping more than 20% during the third quarter, CVX and XOM were both battered and more investors wondered if their dividends were safe. While each stock has recovered over 20% from its low reached in late August, the risk profiles of these oil giants are different. XOM remains one of our top dividend stocks, but we continue evaluating both businesses and the safety of their dividends.
Let’s start with CVX. As seen below, CVX has failed to generate free cash flow this year, losing $1.8 billion YTD (-$7.2 billion, excluding asset sales). Including total dividend payments of $6 billion, the company’s cash drain has been $7.8 billion YTD.
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If nothing changed, CVX’s cash balance ($13.2 billion) could continue funding the dividend for about the next year before running out of funds. CVX is pulling several levers to keep the dividend alive, including debt issuance ($8 billion YTD), additional asset sales (another $5-10 billion targeted through 2017), capex reductions (down 15-20% this year and another 25% next year), workforce reductions (laying off 10% of its employees), and production volume growth (production to grow by 15-20% from 2014 to the end of 2017 from existing projects).
Many investors were pleased to hear the company’s CEO reiterate his commitment to the dividend and reaffirm his expectation that CVX’s free cash flow will be able to cover the dividend by 2017, which would represent a substantial improvement from today’s coverage. When this claim was initially made, it was based on the assumption that oil prices would average around $70, not the $50 they trade at today.
To make the numbers continue to work, CVX will significantly cut its capex, targeting a 25% reduction in 2016 after a 15-20% slash this year. The company also announced it will lay off around 10% of its total workforce. These are pretty drastic measures for a company of CVX’s size to take and, when coupled with the firm’s lack of dividend increases for the last seven quarters, underscore the severity of the headwinds that CVX faces.
We do not think investors should take CVX’s 2017 target for granted – there is plenty of execution risk involved here. The company now expects capex of $20 to $24 billion in 2017 and 2018. Using $22 billion capex as a midpoint and assuming the dividend amounts to about $8 billion, CVX would need to generate at least $30 billion in operating cash flow compared to its current pace of $21 billion YTD. If production growth boosts cash flow by 15% ($3.2 billion), a $5.8 billion hole remains that will need to be filled by asset sales, further capex reductions, cost cuts, debt, or higher oil prices. While the dividend looks safe for at least the next 1-2 years, oil prices eventually need to rise for CVX to continue its dividend and return to sustainable earnings growth.
It also seems like CVX is trading off long-term growth opportunities for near-term dividend protection given the major capex cuts. During its Q3 earnings call, the company moderately reduced its 2017 production guidance, reflecting potential for major capex cuts to impact production rates. Less than two years ago, CVX expected 2017 capex of $40 billion, nearly double its projection today. While this might help its credibility the next few years by protecting the dividend, it could prove to be a rather poor business decision beyond 2018.
As previously mentioned, a major factor CVX is banking on to cover its dividend with free cash flow is the expected contribution from major growth projects it initiated around 2010 that are expected to boost total production by as much as 20% from 2014 to the end of 2017.
Up until 2012, CVX had executed well on its big projects. However, it has suffered numerous mishaps in recent years. Its $5 billion Big Foot project was initially expected to commence production in early 2015 but is now not expected to see any production through 2017. Wheatstone is running a bit behind schedule and facing higher costs as well, and the $54 billion Gorgon liquefied natural gas (LNG) project in Australia (47% owned by CVX, 25% owned by XOM) is a year late on its timetable and close to double its original budget. However, Gorgon is nearly complete now and on track to begin shipping by the end of 2015, and Wheatstone is over 60% finished with production scheduled for next year.
According to a note from Barclays, CVX’s upstream capex rose from an annual average of $17.9 billion between 2007 and 2010, or $18.4 per barrel of energy, to $32.8 billion between 2011 and 2014, or $34.5 per barrel of energy, an increase of nearly 90%! Perhaps this is evidence that management was overly ambitious with development plans, resulting in the delays and cost overruns of the past few years.
Assuming there are no additional execution issues, we remain cautious about the ultimate profitability of these oil projects once they ramp up production. In 2010, when initial decisions were made, the price of oil averaged $90, nearly 100% above today’s price. Given CVX’s ambitious development plans and the unprofitability of its upstream operations today, hopefully these projects can positively contribute to the bottom line (the Wheatstone and Gorgon LNG projects are backed by long-term contracts, however).
Regardless, investors are taking on more execution risk (e.g. project completions, asset sales) with CVX’s dividend compared to XOM’s – CVX’s business is not generating free cash flow, its likely hurting its long-term growth prospects as a result of its severe capex cuts, major growth projects still have execution risk and financial uncertainty, and the balance sheet can only be tapped so much if low oil prices persist.
On the other side of the table, XOM is the best-run integrated oil company in the world, judging from its high return on capital employed compared to its peers. In 2014, XOM’s upstream profitability of $19.47 per barrel led competitors and increased by 8% from 2013. Despite reporting an operating loss in Q3, XOM’s upstream operations loss per barrel was still just half of CVX’s loss and it generated higher margins in international markets. The company has also maintained a reserve replacement rate in excess of 100% for more than 20 straight years, again topping CVX, which reported reserve replacement rates of 89% and 85% in 2014 and 2013, respectively.
Unlike CVX, we can see that XOM continues generating positive free cash flow ($5.8 billion YTD vs -$7.2 billion YTD for CVX, both excluding asset sales) and has a dividend funding gap about one third the size of CVX’s gap ($1.1 billion Q3 gap for XOM vs $2.9 billion Q3 gap for CVX). While XOM has less cash on hand ($4 billion compared to CVX’s $13 billion), its cash dividend coverage is about the same as CVX’s because its cash generation is so much healthier. Importantly, XOM has sold off just $1.6 billion of assets YTD compared to CVX’s $5.4 billion and maintains excellent access to liquidity.
Taking a closer look at each company’s leverage situation, we can see that their amount of net debt has about doubled over the past year, but each maintains a rock solid credit rating. Both companies maintain a reasonable amount of debt relative to total capital, suggesting they should have no problem adding additional debt over the next 1-2 years within reason.
Let’s take a look at each of their dividends.
From a dividend safety perspective, XOM is on stronger footing and appears to be the best house in a bad neighborhood. Regardless, both dividends look secure through at least 2016 even if oil remains at its current price.
Looking at implied EPS payout ratios based on consensus earnings estimates the next few years, we can see that XOM is in a much stronger position and that the next two years are especially challenging for CVX – recall that its normalized EPS payout ratio didn’t even exceed 60% during 2009, and it is not generating free cash flow today.
As we have previously mentioned, it seems likely that both companies will need to tap debt markets again over the next year or so. S&P gave XOM and CVX “negative” outlooks last month, noting that XOM “has substantially more debt than during the last cyclical commodity price trough in 2009, while upstream production and costs are at similar levels.”
However, XOM remains one of just three US industrial companies to have a triple-A bond rating (Johnson & Johnson and Microsoft are the other two). CVX maintains a strong double-A bond rating, and both companies have held their strong credit rating since at least the mid-1980s. With continued access to debt markets, improving cash flow generation, and additional asset sales, we think both companies’ dividends can ride out the oil storm for at least the next 1-2 years.
From a dividend growth perspective, XOM has increased its dividend for more than 50 consecutive years, and CVX has raised its dividend for nearly 30 straight years. They are both some of the biggest companies in the 2015 list of S&P Dividend Aristocrats.
XOM most recently raised its quarterly dividend by 5.7% per share earlier this year, while CVX has kept its dividend unchanged for the last seven quarters, reinforcing the greater cash flow pressure that its business faces. We think CVX will increase its quarterly dividend by a penny next year (less than 1%) to keep its streak alive, and XOM will likely raise its dividend by no more than 3-5%.
In order to give CVX credit for its major growth projects nearing completion (recall that CVX expects production to grow by 15-20% from 2014 to 2017), we will look at its consensus earnings estimates for 2017 and 2018.
CVX trades at about 14x 2017 consensus earnings estimates ($6.61), which begin to account for its higher production rate and bake in a moderate rise in the price of oil. To keep the comparison apples-to-apples, we will also use 2017 consensus earnings estimates for XOM. XOM trades at about 15x 2017 earnings estimates ($5.50). There are fewer estimates available for 2018, but XOM trades at about 14x 2018 earnings estimates and CVX is closer to 12x earnings.
In other words, after factoring in meaningful production growth, CVX’s earnings are being valued similarly to XOM’s despite the higher quality of XOM’s operations, its lower execution risk, and superior growth prospects looking out beyond 2018 (CVX is cutting its capex much more aggressively, and its reserve replacement was just 89% in 2014 compared to XOM’s 104%).
Both of these oil majors are pulling levers to generate more cash flow and make use of their strong balance sheets to protect their status as dividend aristocrats. Compared to XOM, CVX’s ability to sustain its dividend payment appears weaker without meaningful external financing or excessive capex reductions that could hurt longer-term production growth. Regardless, both dividends look safe for at least the next 2 years, barring a further drop in the price of oil.
While many income investors are probably enticed by CVX’s 4.6% dividend yield, which is considerably higher than XOM’s 3.5% yield, it’s important to remember that CVX ultimately needs more to go right (e.g. project execution, cost cuts, debt financing, oil prices) if it is to continue paying and raising its dividend beyond the next few years.
As we discussed in our article about living off dividends in retirement, it is important to remember that income is only part of a portfolio’s total return equation. With both companies trading at similar 2017-18 earnings multiples, we will opt for the higher quality business in XOM every time.
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