There has been much prognostication on the Exxon Mobil (XOM) dividend both here at Seeking Alpha and within the financial press. All that spilled ink is no surprise given the dividend yield has crossed into double digits, long heralded as a sign that at the payout as unsustainable – or at least according to market consensus. Why so much interest? Correctly calling a dividend cut on what still is a cornerstone income position for many retirees would certainly win any analyst or financial blogger some internet brownie points. Nearly all do not have the conviction to put capital at risk on that call by being short.
As something of a dividend cut soothsayer myself – Vermilion Energy (VET) and Occidental Petroleum (OXY) were two public energy bearish calls this year from me that explicitly called prior fat payouts unsustainable – I’d relish in the opportunity to make that call here. Problem is, I don’t think you can. While bulls certainly have had blinders on when it comes to both operational problems at Exxon Mobil as well as the relative valuation compared to direct comps, to me it seems like the bears are well ahead of themselves in forecasting a cut.
Why Dividends Get Cut
For any analyst or independent investor to make accurate (and timely) dividend cut calls, there are two (very) simple catalysts that have to be watched out for. This is quite broad brush, but readers will find that Exxon Mobil does not really check any of these boxes.
Before we get started here, yes Exxon Mobil has burned through quite a bit of cash this year. My working model for the supermajor calls for about $17.0B in operational cash flow (inclusive of a working capital hit) in 2020 against $19.2B in capital expenditures and $14.8B in dividends. That is a gaping hole, with Exxon Mobil slated to only generate half of what it needs to be viewed as “sustainable” business as far as its obligations are concerned. That weakness is likely to not be sustained; 2021 and 2022 look much different. Higher future oil and gas strip prices alongside much better downstream / chemicals margins is expected to move operational cash flow to $27B and $33B per year, respectively. In other words, the delta between “money in” and “money out” effectively closes by 2022.
In most cases, dividend cuts are caused by financial troubles causing distress higher up in the capital stack. Creditors, at the end of the day, call the shots. Nearly every public company out there is reliant on the continued gravy train of cheap, easy access to credit; Exxon Mobil is no different. Whenever a situation crops up where a company is either 1) in danger of violating debt covenants 2) unable to refinance its debt or 3) likely to see significantly higher interest expense upon refinance, management is nearly always forced into cutting returns to shareholders in order to realign the structure to be more stable.
None of these problems exist for Exxon Mobil, unsurprising given its credit rating. As an example, CUSIP 30231GAN2 is an Exxon Mobil unsecured bond issued back in 2015, maturing all the way out in 2045. Such a long-dated security is a great window into the minds of creditors. How this bond trades illustrates how safe these investors feel their money is over a period of decades.
As shown above, even though the relative risk of this particular piece of credit has increased – investors are demanding higher returns now versus issuance compared to 30 Year US Treasury Bonds – these bonds actually trade stronger today than they did at issuance. In other words, if refinanced today Exxon Mobil would actually cut interest expense. This is true of nearly all of its debt structure.
While there could be savings by cutting the dividend, those savings would likely be incremental (<50bps) and realized over a long period of time. In other words, there is very little net present value from a cut. While this is a snapshot and might change down the line, the reality is there is no pressure on Exxon Mobil to cut. If I’m CEO Darren Woods, my thought process today is something along the lines of: “Lower global demand and weak commodity prices has really harmed the outlook for Exxon Mobil earnings this year. However, futures prices and continued improvements in worldwide economies will close the gap in the coming years. Meanwhile, our access to credit remains strong, with the firm still enjoying some of the lowest risk spreads in energy versus the risk free rate; there is little to no risk of not being able to access borrowings.”
That is pretty much what public statements have echoed.
- Management / Board of Directors Strategy Reversal
For a variety of reasons, management might change their minds on strategy. This does not necessarily mean that they have “flip flopped”; it could be because of new events (lowered outlook) or even new opportunities (potential acquisitions). At least for now, this appears to not be the case at Exxon Mobil. Management has repeatedly emphasized that dividend preservation is the number one priority during the down cycle and that – just like in prior periods – it might run deficits because part of the ethos of the firm is to be contrarian, investing in times of distress.
Funding the dividend is something that has multiple levers to pull without borrowing. Recent cuts to the capital expenditure budget are the most clear means of capital preservation, and while this likely saves north of twenty billion over the coming years, major projects continue to be emphasized. Asset sales are also on the table as a means of raising cash (the divestiture program remains open), although sales are likely to be light because of pricing. Nonetheless, shedding assets that do not fit within the overall strategic direction could be sold for the right place.
I think it’s important to remember that senior executives, by their very nature, tend to think highly of themselves. Strategy changes do not come often, and outside of a firing of the team by the Board of Directors – not likely here – in my experience the most likely avenue of change is prompted externally via shareholder activism. There have been rumors of this of late, but in my view the relative size of Exxon Mobil really limits the pool of activists that could take a (at minimum) 5 – 10% stake necessary to put pressure on the Board of Directors. Even then, activists might not even put focus on the dividend, instead potentially trying to address the discount via other means (spin-offs, cuts to overhead, shifting capital focus to different segments).
Overall, there is very little sign here (to me) that either management or the Board of Directors are going to brake off the current path – at least given the current outlook. A second wave or other global economic shocks could change that, but for now Exxon Mobil remains pot committed on its allocation strategy. A divergence now, months after the depths of the crisis and a stunning rebound in the credit market, would be viewed as doing more harm than good in the short and long term.
Likely worthy of its own research note, but I think earnings estimates are a tough light at Exxon Mobil which does help close some of the cash flow gap this year. For one, expect some upside out of the Permian Basin in particular. While production estimates in the area have come down quite a bit this year form analysts because of Q2 shut-ins and guidance towards operating just 10 -15 rigs by December, remember that pretty much all the production from unconventional plays is now back online. Further, Exxon Mobil has hundreds of drilled but uncompleted wells to tap in its core operations around Poker Lake (Eddy County), perfect to utilize in a year where management wants to show flat production figures but has significantly fewer investing dollars to do so. While guidance already implies a healthy positive comp compared to 2019 from Exxon in the Permian, expect a beat here.
Up north – and unfortunately probably a headwind in Q3 – also expect strong results out of the Canadian operations to finish 2020. Kearl Line 1 was undergoing planned maintenance in August and subsequently operations in the area were shuttered in September after a pipeline spill on a diluent line. With the Polaris Pipeline now back online (there was some fear regulators would require heavy maintenance and a more detailed plan to bring it back online safely), Kearl is now back up and running, moving heavy crude down to the Gulf Coast. Canadian differentials are tight currently (positive for those with oil sands operations) and Exxon Mobil will benefit more than others as much of which finds itself being used in Exxon Mobil refineries. Crack spreads there, while certainly tepid, are well off the lows.
Outside of Upstream, I also really like Exxon Mobil’s polyethylene / polypropylene assets. Really weak pricing on finished products currently because of a market-wide supply and demand imbalance, but this area of the market should see a strong recovery into next year. Plastics were a bit hard hit from the automotive industry, but other aspects of the business should continue to see strength (healthcare, consumer packaging) as the automotive business recovers.
Calls for dividend cuts make for great clickbait headlines. In my opinion, analysis calling for a cut might be grounded logically based on current cash flows, but unfortunately ignore the realities of future earnings improvement and management incentives. There is more to making a right call than a near term financial cash flow model. While owners of the firm should not have their head buried in the sand on its problems – Exxon Mobil is not cheap against upstream/downstream peers and it does have operational challenges to navigate – income investors should still sleep soundly when it comes to dividend safety.
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Disclosure: I am/we are short OXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.