The recent weakness in oil and gas prices has put the squeeze on energy businesses, and Chevron (CVX +1.62%), one of the world's largest integrated energy companies, is no exception. Chevron recently reported a big earnings miss, with its worst quarterly profit in 13 years. As you can imagine, questions were raised about the entire sector and the sustainability of dividend yields.
What about Chevron's dividend? Let's examine how safe it may be in this challenging environment.
The payout
Chevron has increased dividend payments for 28 straight years, and it's paying out around $8 billion per year to shareholders as of late. Back on Oct. 30, management stated its goal to continue to grow the quarterly dividend. The company will do everything in its power to make that happen. We've seen this already with capital spending cuts and debt issuances. Alas, the company has no control over oil and gas prices. The longer oil prices stay down at these levels, the more difficult it will be for Chevron to continue paying the current dividend.
Before 2013, the company was able to cover the dividend from free cash flow. However, the company currently generates no free cash flow to speak of in this low-priced commodity environment.
The company has $13.2 billion in cash, so theoretically it could cover the dividend for another 1.65 years. Of course, this assumes no cash coming out to cover losses from a depressed commodity environment. However, it's unlikely to part ways with that cash as a buffer against a potential liquidity crunch. Over the past three years, the company has been able to issue debt of $17.66 billion to help pay for the $22.42 billion in dividends. This strategy usually works until it doesn't, and then it ends all at once.
Long-term debt has more than doubled in the last three years. As you can imagine, this increase will put a further strain on cash flow that will need to be used for interest payments to pay off the debt burden of $1.1 billion by 2019. Long-term debt coming due by 2019 stands at about $18 billion, but they are expected to refinance those debt burdens.
Image Source: Chevron investor presentation
However, management states that a healthy dividend is its No. 1 priority, and it says it's "committed" to covering the payout from free cash flow in 2017. That feels to me as if management is trying to buy time for commodity prices to turn around. Picking the future of energy prices is not an easy game. Any projects coming online will have a difficult time making money in this depressed commodity environment, so it's important to have an understanding on future of oil and gas prices.
The future of oil and gas prices
To have any outlook on the future of the dividend payout, we need to understanding where the underlying commodity environment will be in the future. The company could probably issue dividends for another two to three years through cash and additional debt issuance, and asset sales. However, the issuance of dividends will become exceedingly more difficult in a continued low-price environment. Management is well aware and is focused on maintaining the dividend and growing it as cash flow permits.
Image Source: Chevron Investor Presentation
The goal is to balance cash by reining in current projects and reducing capital spending and operating expenses. It will also continue to sell assets where it's getting good value. Upstream earnings have taken a hit in this low-priced commodity environment, and the market has seen an influx of production in the past few years that has outpaced demand. However, the market is beginning to show signs of a rebalancing, with rig counts coming down and worldwide liquid supply and demand coming back in line.
The increase in production from Saudi Arabia and increased shale production in the U.S. produced a glut of supply in late 2014 that the market has been trying to work off ever since. But global energy demand is expected to grow by about 35% by 2040, so the drop in supply and increase in demand should help to forgive a multitude of sins and provide a wave of future demand growth to stabilize prices.
The call
As much as long-term investors will hate to hear this, I'm going to go out on a limb and say that these companies should probably cut their dividends. Many have room right now to cut dividends in half. Initiating dividend cuts without suspending the payouts will allow the companies to remain in their various income funds while still paying decent dividend payouts to investors. Also, the cutbacks will help stabilize the balance sheets. These companies aren't getting a premium for issuing a dividend right now.
It will be much easier for a company such as BP to cut dividends because it's done so in the past. Companies such as Exxon and Chevron have an untarnished dividend history, and that will make it harder for them to cut. That still doesn't mean they shouldn't do it.
Bottom line
In general, oil and gas companies have dividend payouts that are unsustainable in this low-priced commodity environment. Some companies, including Chesapeake Energy (CHK +0.00%), have scrapped their payouts altogether. But just because these companies should cut their dividends to some degree doesn't mean they will.
Chevron is a different breed because of its integrated business model -- it's one of a handful of companies with the potential to ride out the storm without cutting its payout. The company will do everything in its power to keep its dividend intact, and it should be able to do so through cost-cutting initiatives, asset sales, and debt issuance, as well as paring back the share-buyback program. It won't be pretty, though. Everything ultimately depends on how long we remain at these depressed oil and gas prices, but I expect Chevron to keep dividend payments consistent with today's payouts, even with energy prices at current levels.
Oil and gas prices should recover from depressed levels as production levels off and demand increases because of lower prices. Ultimately, this situation will allow the cash flow and subsequent dividend payouts to come back into balance. As is usually the case, the timing is always less sure. The longer prices stay in a sub- $30-$40 range, the more worried I will be. However, Chevron's 5.25% dividend yield appears to be safe -- for right now.
