Market Down, Oil Up, Shell Cuts Dividends

After a string of positive days, today global equity markets stepped back. The S&P 500 fell 0.9%, the Dow Jones Industrial Index fell 1.2%, and the S&P/TSX Composite fell 2.9%.

There's no specific catalyst for this selling. US initial jobless claims once again reached a jaw dropping level, with now 40% of Kentucky's labour force out of work, but those numbers haven't moved the needle much in previous weeks.

Oil continued its gains since bottoming out awkwardly last week, with the price of Brent crude over $25/bbl.

Brent Crude Price | Source: Bloomberg Apr 27, 2020

Shell Cuts Dividends for First Time Since 1943

Oil companies don't have a lot of different tricks to offer investors. The product is a commodity, which means that they can't differentiate it or innovate a new and more exciting form of oil. They all have rebranded as "energy" companies and tried to diversify away from oil, but oil production represents the vast majority of their profits and earnings. Royal Dutch Shell's "New Energies" initiative is nice and all, but it's not why most shareholders invested in the first place.

People invest in oil companies because producing oil is an extremely durable way to produce cash flow. Oil is the lifeblood of global economic activity, and whether it sells for $20 a barrel or $100 a barrel, it sells. Even as the global demand for oil has declined dramatically, it remains north of 65 million barrels a day. Profits fluctuate, but there's always a way to produce cash flow making something that the world consumes 2.7 billion gallons of a day. Durable cash flow means durable dividends, and oil majors have typically been extremely hesitant to cut their dividends, even if it meant taking a loss in the odd year.

Today, that dynamic broke. Royal Dutch Shell announced that it cut its dividend for the first time since 1943, and by more than 60%. There are a lot of good reasons for the cut, most of which revolve around the company no longer needing to meet a $15 billion/year dividend obligation. 

There are a lot of reasons for investors in Shell and other oil producers to be concerned. One of the supermajors cutting its dividend opens the door for smaller companies to do the same, and we could see a domino effect of dividend yields falling.  

Our Outlook

• As we've been recommending a basket of shares in large, dividend-paying companies, news of Shell's cut is obviously concerning to us. Here's what we're taking comfort in:

• The energy company we typically recommend, Enbridge Inc, is not a seller or producer of oil, never mind both. It is a midstream transporter of oil, whose profitability is less geared to the price of oil than a producer's.

• Shell's dividend was much higher, as a percentage of share price and as a percentage of earnings, than most of the names in our basket. Before this cut, Shell was paying roughly 75% of its earnings out in dividends. Most of the names in our portfolio have a dividend payout ratio of less than 50%

Could we see dividend cuts soon? Very likely. We won't see them evenly distributed around the market, however: not everyone's 2020 cash flow prospects look the same, not everyone's plans for the future require diversifying into a totally new way of generating industry, and not everyone makes a point of never cutting dividends. By targeting names that can generate good cash flow this year, names (like banks) that don't need to get out of their primary line of business in the next few decades, and names that haven't cut their dividends in decades, we hope to avoid those cuts.

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