Oil price shocks: putting dividends at risk?

Saudi Arabia’s decision to start an oil price war caused the market value of the sector’s biggest companies to fall sharply this week.

Having attempted to get other OPEC countries and Russia to cut production to support oil prices, amid concerns that the Coronavirus will threaten global oil demand, Russia’s refusal led Saudi Arabia to instead discount its crude prices and raise its own production.

The drop in oil prices from $45 on Friday to around $35 on Monday caused the likes of UK oil giants Royal Dutch Shell and BP to lose more than £32bn from their combined market value within minutes of the London Stock Exchange opening.

What does this mean for dividends?

A prolonged oil price war could force oil companies to rethink their dividends. According to Schroders, if oil prices average $35 per barrel for the rest of 2020, full-year cash flow for the integrated oil companies will reduce by between 50% and 60%. “While we don’t think dividend cuts will happen in the short term,” a spokesperson said, “without a crude price recovery dividend cuts are a certainty. No part of the oil industry works at $30 a barrel.”

This is significant for UK investors that rely on dividend income. “The UK stock market’s dividend yield of 5.8% seems too good to be true,” they continued. “That is because it is. 17% of UK dividends in 2019 came from the energy sector*. BP and Shell were two of the three biggest dividend payers.

“After Monday’s oil price crash, they now trade on dividend yields of 10% and 11% respectively**. This is the market’s way of telling you that those dividends are likely to be cut or eliminated entirely, at least temporarily. However, even if you were to conservatively write down the energy sector’s dividends to zero, that would still leave the UK market yielding around 4.8%.”

“The drop in the oil price makes it more likely that some oil producers will also default on their debts, according to Julian Chillingworth, chief investment officer at Rathbones.

“That could have an impact on the wider bond markets,” he said, “given more than 10% of the US high-yield bond index is made up of oil producers. Government bond yields also plunged on Monday, with the US 10-year Treasury yield down more than a quarter-point at a record low 0.50%.”

Different investors see this situation in different ways. For example, the managers of Artemis Income fund have been reducing their exposure to oil over the past year. At the end of February, their oil and gas weighting was half of the benchmark (5.25% versus 10.5%.) because they have structural concerns regarding oil companies’ dividends: “Will they need/be forced to re-invest the cash that currently pays dividends to secure a green future?” they asked.

David Coombs, manager of Rathbone Strategic Growth Portfolio has done the opposite this week: “We have added to our oil holdings,” he said. “Their share prices are lower now than in 2015 when Brent Crude was $25.”

Darius McDermott, managing director of FundCalibre, added: “Short term, it won’t be a problem. But if the oil price stays low for a long time then it could certainly result in dividend cuts – the oil sector’s cash flow will be hit hard. But oil at this price helps no one. Not the Russians, not the Saudis, not the Americans. And it’s not sustainable. So hopefully they will all back off soon.

“In the meantime, it just reminds us that it pays to have a diversified income stream and not rely on a handful of companies to pay your dividends.”

Three funds to consider for diversified dividends

Global dividends: BNY Mellon Global Income

Run by one of BNY Mellon’s boutiques Newton, this is a value-biased global equity income fund designed to generate a yield at least 25% greater than that of the global stock market. Experienced manager Nick Clay uses Newton’s impressive analyst resource to exploit macroeconomic themes and pricing anomalies at the company level.

Sustainable UK dividends: Royal London UK Equity Income

This fund invests in high yielding UK stocks, with a particular emphasis on companies that generate significant free cashflow to finance sustainable dividend payments. 90% of holdings are in large and medium sized businesses, it does not invest in bonds, derivatives or unquoted companies and the manager does not make big macroeconomic calls. It has been extremely consistent, outperforming its peer group in nine of the past 10 years.

Dependable dividends: City of London Investment Trust

Alternatively, if income stability is very important, investors might like to consider City of London Investment Trust. It has a bias towards larger companies and has the added comfort of a ‘revenue reserve’ should UK dividends come under pressure. This facility has helped its current and previous managers to increase dividends each year for the past 53 years.

*Source: UK dividend monitor, Q4 2019, Link Group
** as at 9 March 2020