One of the best ways to avoid financial risk in your life is to avoid debt. That's not always possible, given the cost of homes, cars, and education, but the less leverage you have, the more financial flexibility you will have. That same statement is true for companies. This is why ExxonMobil (XOM 2.97%) and Chevron (CVX 2.22%) have been able to navigate the energy patch while still rewarding investors with decades of annual dividend increases.
No good options
Assume a company uses leverage to fund an acquisition. That debt shows up on its balance sheet, and the increased interest expense appears on the income statement. What happens if the purchase doesn't pan out as planned or the core business starts to falter? The answer is that the debt and interest expenses associated with the deal stick around while the top and bottom lines suffer.
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The lender doesn't care that management made a mistake; it still wants to get paid. That can quickly put the company that borrowed the money into a tailspin, with few desirable choices for keeping the business afloat. Too much leverage is one of the most common reasons a company ends up in bankruptcy court. That is why investors should always look at a company's balance sheet to assess debt levels and the income statement to determine interest coverage.
This gets a little more complicated for energy stocks since the industry itself is highly cyclical. High oil prices can lead to robust profits, while low prices can lead to a lot of red ink. Clearly, it is easier to handle interest and debt issues in good markets. It is the bad markets that investors need to think about first since even well-positioned companies may not be able to fully cover interest costs. Exxon and Chevron are probably the best-prepared of their similarly managed integrated energy peers for the next downturn.
Some numbers
Chevron's debt-to-equity ratio is roughly 0.17 times today, which is low for just about any company. Exxon's ratio is still a fortress-like 0.26 times. The next-closest integrated energy peer, Shell, is at 0.44 times, TotalEnergies comes in at a 0.53 times, with BP pulling up the rear at 0.79 times. But remember, these are the good days.
When the going gets tough, energy companies tend to lean more heavily on their balance sheets to help them support capital investment plans and their dividends. For example, during the 2020 energy market downturn, Exxon's debt-to-equity ratio peaked at around 0.4 times, and Chevron's rose to 0.33 times. This pair's European peers saw much higher levels, with BP again pulling up the rear with a peak debt-to-equity ratio of over 1 time.
Here's the interesting thing: BP and Shell both cut their dividends in 2020 as they looked to reset their businesses and increase their exposure to the hot clean-energy space. You could argue that the energy transition was the impetus for the cuts. But the truth is that, even without having to pay for expensive business shifts, the pair would have had a hard time investing in core operations. Cutting the dividend helped free up cash for their capital spending needs.
While Exxon and Chevron didn't change their business approach, they also didn't need to cut their dividends because there was plenty of room on their balance sheets for the debt they added. To be fair, TotalEnergies announced a similar clean-energy pivot and didn't cut its dividend. However, its dividend yield spiked higher than either Chevron's or Exxon's in early 2020 because investors were worried it had too much debt.
Note that Chevron and Exxon are both Dividend Aristocrats, having increased their annual dividends through thick and thin for more than three decades each. TotalEnergies' dividend record simply isn't as good. The robust financial strength of Chevron and Exxon was pivotal in their ability to consistently reward investors.
Solid as a rock
To be fair, European integrated energy companies tend to hold more debt and more cash, with U.S. peers Exxon and Chevron opting for lower debt and less cash. But they aren't the same thing. When times are bad, it is much easier to lean on a balance sheet with less leverage than it is to use up emergency cash and add even more debt to a debt-heavy balance sheet. Chevron and Exxon are simply better positioned to weather the energy sector's ups and downs, and their fortress balance sheets are a key factor. If you are interested in an energy stock today, think first about what will happen when things aren't as good as they are now. In that scenario, Exxon and Chevron are likely to stand out in a very good way.
