WHY BIG OIL NEEDS TO CHANGE ITS APPROACH TO DIVIDENDS

The collapse in oil prices has been met with a response all too familiar for investors: Senior executives at Big Oil companies cut pay and expenses, lower head count, reduce upstream spending in areas such as exploration, and sell assets to protect both the dividend and credit rating.

Things are a little more extreme this time around, but the playbook is essentially the same.

Fred Lucas, an analyst at J.P. Morgan Cazenove, who covers the European oil and gas sector, thinks more permanent and structural changes are needed given how deep and long the current oil price cycle is looking.

“In our view, the sooner Big Oil embraces the need for structural change, the better,” Lucas said in a research report.

He believes inflexible dividends can make cyclical inefficiencies worse, as they often lead to spending cuts and portfolio shrinkage at a time when asset prices are depressed and bargain hunters are on the loose.

“Big Oil is the repeat victim of the cycles that it perpetuates,” the analyst said. Lucas highlighted Statoil

ASA as a likely dividend casualty, forecasting its payout will be cut by 30 per cent in February. But a similar risk applies to energy companies across the globe.

One reason oil and gas executives are so tied to their dividends is that they don’t want to break the commitment established by their predecessors.

The earnings and cashflow volatility that comes with investing in the energy sector also makes it difficult for investors to establish sustainable growth trends, so dividends are used by Big Oil to signal confidence in future growth.

However, the analyst thinks it is finally time for Big Oil to exploit the oil price cycle, rather than the other way around.

One possible way to do that is to establish an earnings payout dividend model that sets a percentage target payout over a period of time, and then couple that with a more flexible share buyback policy.

“Total distributions across the cycle may not be very different, but the timing and form of distributions would be radically different,” Lucas said.

That would allow companies to invest more near the bottom of the cycle and less through the top, making Big Oil less correlated with oil prices.

He also pointed out that Big Oil’s underlying growth rate is too slow to allow for anything other than ongoing equity retirement throughout the cycle. Equity issuance is generally undesirable, but it’s particularly unwanted at the bottom of the cycle.