Can Big Oil Keep Paying High Dividends?

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Low oil prices have compelled the Italian oil company Enitoslash its dividend, the first major oil company to do so. With the biggest oil companies struggling to generate cash, could Eni merely be the first among many to make such a move?

The decision to slash its dividend underscores the predicament facing the largest oil and gas companies around the world. The utter collapse in oil prices is blasting a giant hole in their balance sheets, forcing dramatic cut backs in spending.

But dividends have been zealously protected by oil firms, which have historically opted for spending cuts rather than reducing payouts to investors. Even in the face of lowered future production, dividends have taken priority. Royal Dutch Shellhas not cut its dividend since 1945. ExxonMobil has increased its dividend each year for over three decades, and has paid out adividend for more than 100 years, dating back to the days of Standard Oil. With generous and consistent dividend policies, the oil majors have been seen as "widows-and-orphans" stocks, or low-risk investments that generate a stable return year after year.

However, Eni's decision to lower its dividend offers an early warning sign for the industry.

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None of the largest oil companiesare going to be able to fund their stated dividend policies from actual cash that they generate this year from selling oil and gas. For example, after spending $31 billion on operations and paying out an additional $8 billion in dividends in 2015, Chevron's projected $22 billion in cash flow is expected tofall significantly short.

That would suggest the dividend would need to be reduced, but considering how adamantly they guard payout levels, the oil majors are going to need to find other ways to pay shareholders. That means taking on more debt, selling off assets, canceling share buy-back schemes, or most likely, a combination of all three.

Indeed, many of the oil majors are in the midst of major asset sales, spending cuts, and retrenchment. In the short run, taking on new debt is not necessarily a problem. The oil majors have stellar credit ratings bizarrely, ExxonMobil has abetter credit ratingthan the U.S. government. That should allow them to borrow without much trouble for quite some time. But if they have to take on more debt, the markets will eventually start to grow weary, and then their credit ratings will slip. That would raise the cost of borrowing, further calling into question the sustainability of their dividend policies, and more importantly, the profitability of their businesses.

There comes a point at which dividends have to be slashed in order to keep their exploration budgets going. Or put another way, is it more important for companies to pay shareholders now, or invest in future production? Although the stock market punished Eni for its decision, maintaining the higher dividend risked "skewing strategy to protect it," the Swiss bank UBSsaidon the news.

Ultimately, it all depends on two things. First, the price of oil. Oil prices are expected to rebound in the coming months and years, but how quickly is anybody's guess. Adding to the industry's problems is the fact that not only are oil prices at their lowest levels in six years, but natural gas prices have also declined both in the U.S. and abroad,hovering near three-year lows. The oil majors are really oil and gas majors, and lower natural gas prices will also cut into profits.

The second thing that will decide the fate of these firms is their ability to find and produce new oil and gas. And for the industry there is not great news on that front either.

Even when disregarding the collapse in oil prices in the second half of 2014, last year turned out to be the sector's worst in decades. The volume of new discoverieswas the lowest since 1995, and perhaps the worst in sixty years. It was the fourth year in a row that new discoveries fell, the worst streak since 1950. Not a single new "giant" field was discovered.

The oil majors are struggling to boost production, despite high spending levels. ExxonMobil spent $38 billion in 2014 but sawits production dipby 2 percent.

"Energy is not a growth sector," wrote Morgan Stanleyanalyst Martjin Rats in a recent note, as reported byBarron'sin February. "Almost by default, the appeal of Big Oil to investors has to be the large amount of income they distribute." But, as Eni acknowledged when it slashed its dividend, even that is not a certainty.

The article Can Big Oil Keep Paying High Dividends? originally appeared on Fool.com.

By James Stafford of Oilprice.com. Oilprice has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.