Energy Dividends Require Positive Free Cash Flows

Energy Dividends Require Positive Free Cash Flows

November 01, 2020

Energy Transfer just announced it was reducing its dividend by 50% starting with the quarterly payment being paid this month. Although the market is now looking to energy stocks for yields, given the low rates available in fixed income securities, this cut should not have been surprising.

Energy Transfer’s previous annual dividend of $1.22 per share resulted in a trailing dividend yield of 23.69% based on current stock prices. This yield is a historical, calculated number and results from the market’s expectation of lower future dividends which have significantly reduced current share prices.

According to Barron’s:

"The energy stocks in the S&P 500 have lost about half their value this year. The sector is littered with dividend cuts and suspensions, as companies have moved to shore up cash positions amid the pandemic and weaker oil prices. This isn’t the ideal scenario for income investors."1

This excerpt from Energy Transfer’s recent investor presentation illustrates the volume dependency on the energy sector as a whole. Currently, there are lower expected demands due to additional COVID-19 shutdowns putting pressure on oil and gas pricing.

Oil and gas reserves begin to deplete from the moment they start production. Increased free cash flows, to service existing debt and hopefully pay dividends, result from increased sales and/or lower expenses and investments. Increased production from new drilling opportunities must be supported by commodity prices allowing investors an expected return of and on their investment, which oil prices less than $40 per barrel may not provide.

According to Bloomberg News, Andrew Swiger, the chief financial officer at Exxon Mobil Corp., summarized the attitude of the whole industry after Big Oil reported another dismal set of quarterly earnings: "Prices will have to rise."2

WTI Strip Prices Decline

Over the past month, futures prices for the WTI contract fell about $3.00 per barrel.

Oil Strip Prices - One Month Decline

one month oil decline chart 

The price distribution below shows the crude oil spot price on November 2, 2020, as well as the predicted crude oil prices based on option and futures markets. The blue lines are within one standard deviation (σ) of the mean, and the red lines are within two standard deviations.

Oil Price Outlook

WTI Crude Oil $/BBL

crude oil November 2020 chart 

Based on these current prices, the markets indicate that there is a 68% chance that oil prices will range from $27.00 and $48.00 per barrel in mid-February 2021. Likewise, there is about a 95% chance that prices will be between $13.00 and $62.00. By mid-April 2021, the one standard deviation (1σ) price range is $27.00 to $51.50 per barrel, and the two-standard deviation (2σ) range is $13.00 to $70.00 per barrel.

Key Takeaways

Remember that option prices and models reflect expected probabilities, not certain outcomes, but that doesn’t make it any less useful. If someone asks you longingly if oil will be at $75 per barrel again soon, you now can respond with "the markets indicate there is a 97.5% probability that oil prices aren’t expected to get above $70 by next April, so I wouldn’t count on it."

  1.  Barron’s "Oil Stocks Offer Big Dividends. Some Might Even Be Safe Enough to Buy.", By Lawrence C. Strauss, Updated October 3, 2020 / Original October 2, 2020
  2.  Bloomberg- With No Cuts Left to Make, Big Oil Sits and Waits for a Recovery, Kevin Crowley, Javier Blas and Laura Hurst, October 30, 2020