The energy sector is deeply out of favor because of the economic shutdowns being used to slow the spread of the coronavirus. Muddling through isn't going to be easy, but both ExxonMobil (XOM -0.74%) and BP (BP -0.95%) should manage the feat. However, is one a better option for investors than the other? Here are some facts to consider before you make a final call.
1. Holding on to the dividend
Exxon's yield is a huge 9.4% today, easily at the high end of the company's historical yield range. It's a sign of just how hard things are right now in the energy sector, and, importantly, just how concerned investors are that Exxon will need to cut its dividend. That is a very real concern given that oil prices are painfully low right now and Exxon has been spending a lot of money on its exploration and development activities. The problem is that it can't just stop investing, because its production would start to decline.
This sets up a massive balancing act for Exxon's management team. It needs to find the cash for its capital spending plans and the money to keep paying its dividend, which has been increased annually for over three decades. So far that's resulted in a mixture of cost cutting, pushing development plans out into the future, asset sales, and increasing leverage. The last one is the one dividend investors need to pay attention to.
At the start of the year the company's debt to equity ratio was around 0.25 times. By the third quarter it had increased to nearly 0.4 times, a huge change in a very short period of time. During Exxon's third-quarter 2020 earnings conference call, management said that it doesn't want to take on any more debt. That leaves it with limited options for supporting both the dividend and capital spending. Note, too, that selling assets during a deep industry downturn isn't exactly a great option.
Still, management seems confident that it can sustain the dividend as long as the energy markets start to get back into a better supply/demand balance. Assuming that happens within a reasonable period of time, investors are likely to reward Exxon with a higher price as its business recovers, and the dividend will likely survive. If it doesn't happen, the dividend could end up getting cut, and the stock will linger at low levels. In other words, buying Exxon is a bet that it can withstand the current headwinds until there's an industry recovery.
2. Shifting toward clean energy
BP has already given up any notion of protecting its dividend during the current downturn, having cut it by 50% earlier in the year. It did that at about the same time that it announced a major corporate overhaul, in which it laid out plans to shift away from oil and toward clean energy. This is a huge deal that will completely reshape the company.
Over the next decade or so BP plans to shrink its oil production by a little more than 40%, with the goal of focusing around better quality assets. Meanwhile, it hopes to expand its low-carbon spending tenfold as it grows its clean energy business. By 2030 it expects 40% of its capital spending to be related to non-oil businesses, such as solar and wind power and electric vehicle charging stations.
Although it is nice to see that BP is changing with the times, there's a small problem here. The company's debt to equity ratio is a huge 1.07 times. That helps explain why it yields around 6.5%, even after a 50% dividend cut. While Exxon is trying to muddle through a downturn with a debt to equity ratio of around 0.4 times, BP is trying to completely remake its business and muddle through with massively more leverage.
Although the dividend cut freed up cash for that effort, that alone won't be enough. BP is also selling assets into a weak market and cutting costs. An oil industry rebound would help, but there's a lot more complexity involved here that won't go away even if oil prices recover. Worse, BP has tried to clean up its act before, and not shown much follow-through. This is more of a special situation story, with a backdrop of excessive leverage and an industry downturn.
At the end of the day, neither Exxon nor BP is a particularly great option for more conservative investors. However, what Exxon is trying to accomplish today is much less dramatic than what BP is looking to do. And, with less leverage, the chances of Exxon muddling through the current downturn without too much difficulty seem higher. Yes, there's a risk of a dividend cut -- but that's probably preferable to BP, which has already taken that medicine. Indeed, BP's plan to completely remake its business in the middle of a deep industry downturn is audacious. However, given the company's elevated leverage and history of falling short on its last clean energy push, it is also fraught with risk.