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Rethinking Dividend-Paying Energy Stocks

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Our equity analysts recently lowered their long-term price forecast for oil and natural gas. I'm here with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy--to see what impact these changes will have on dividend payers.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, can you talk to us a little bit about the lowered forecast and what impact that's had on both fair value estimates and economic moats?

Peters: Well, I can speak about it on kind of a high level. I'm not an energy-industry expert. But over the years, the energy sector has played a pretty good role in the portfolios that I manage. And I've got the advantage of our team of analysts that does a great job tracking what's frankly a really difficult industry. And I like to think of it this way: Chevron (CVX) or Shell (RDS.A) or Exxon (XOM) or Saudi Aramco--you name it--could hire someone and give him an unlimited salary virtually if that person could correctly predict the prices of these commodities. And even they can't do it. So, it is kind of difficult to value these businesses, but that doesn't mean that they don't still have a role to play in portfolios. So, what we've done is revamp our look at the global oil price, as well as natural gas prices in light of the big shift in prices that we've had since the summer of 2014.

Frankly, we didn't see that big shock coming; but what you do as an analyst is if you have been off on something, you go back and you reevaluate. And the biggest change in the story has been fracking in the shale basins in North America. What it's done is it's provided so much incremental production into the global market at a time when global demand growth is not strong--most economies being fairly weak outside of the United States--that it's pushed those higher-cost projects like deepwater offshore off of the cost curve.

Think about it like this: From the bottom, you've got Saudi Arabia that's able to pump oil extremely cheaply; maybe it's less than $10 a barrel. So, everything between that and whatever they can sell it for is profit. But then there are projects that cost $20 a barrel; there are projects that cost $50; there are projects that cost $100. And when there is too much supply growth and not enough demand growth, the price starts to fall, and it's those high-cost projects that you don't need because the supply is coming from lower-cost projects. That's what technology has done in making fracking cost-competitive--not just at the last barrel of oil but at that middle range of the supply curve. And that shifts the whole structure of the oil and gas supply-and-demand downward, such that we've had to reduce our long-term price forecast.

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Glaser: And with that reduction, it also means that fair value estimates have come down somewhat; we've kind of rethought the competitive advantages of some firms. Of the energy names that are owned in your portfolio, what were some of the biggest changes?

Peters: Well, the energy producers that I've owned over the last couple years have been Chevron and Shell. The impact on the fair value estimates was pretty significant. Chevron, for example, came down from $124 a share--and had been $132 prior to that. So, it's two steps down. Now, I believe the shares are worth $114. You might think, "Wow, your price forecast has come from $100 to $75, why shouldn't the fair value be down even more when you consider that these companies have a lot of fixed costs?" But, in fact, there are countervailing factors.

As earlier I said, the cost of producing oil has come down. That's the main reason that the price has come down. And with that, big energy firms--whether they're private western corporations or national oil companies--are going to have lower costs to develop resources. So, yes, revenues are falling, but costs are falling, too. That's a counterbalancing effect. But on balance, we still expect lower profits.

With Chevron, I still think you have a very compelling long-term story to the dividend. Dividend growth is their primary emphasis in terms of shareholder return. They've been investing very heavily because over the last decade, they've had a lot of success with the drill bit. They've really expanded their opportunity set of projects that they could develop. They've spent a lot of money to bring on a lot of production that now, over the next couple years, is going to come on line at lower prices than they expected.

But they'll have a lot more flexibility to reduce future investment or target it differently. And they expect that free cash flow is going to return to a level that will fully cover the dividend in 2017, just two years from now, and at that point grow thereafter. So, still, long term, I think this is like a 6% or 7% long-term dividend-growth story. And right now, yield is around 4%. So, looking at the situation here, I actually added to my Chevron stake even though our fair value estimate had come down because the price has come down even more. I still think the basic dividend story, long term, is intact.

Shell was a different story. Shell and Chevron both had narrow moat ratings, implying that we thought that they both could out-earn their cost of capital, let's say, over a 10-year time frame, and that there were structural reasons to think that they had cost advantages relative to that global supply curve for oil. But Chevron has been much, much more profitable than Shell in recent years.

Shell's been struggling probably for more than a decade now, trying to cope with a wide-ranging portfolio where they made a lot of poor capital-allocation decisions. And in last couple of years, even with $100 Brent crude or thereabouts, they were barely earning their cost of capital then. At a lower global oil price, it could be a very long time before they can restructure themselves into earning just an adequate return on capital, let alone a value-creating one.

So, with that, we downgraded our moat rating. We don't think Shell is an obvious dividend-cut candidate, but they're going to have trouble generating enough free cash flow to cover the dividends over the next five years. They've got plenty of flexibility with their balance sheet; they've reintroduced their scrip dividend, which is the British euphemism for dividend-reinvestment plan. That's going to help plug the cash flow gap, so to speak. But really, I'm not looking for any dividend increases now through the end of the decade under our current price forecast from Shell. Chevron, hopefully, will get small but continued dividend growth in April.

Glaser: By adding to Chevron and eliminating Shell, how does that leave your total exposure to energy? How do you think about the portfolio's exposure to energy as a whole?

Peters: Between the two, I didn't buy as much in additional Chevron shares as I sold out of Shell. So, I took our weighting in the portfolio down a little bit. Shell is now about a 4.5% position in our portfolio. Interestingly, energy, even if you exclude midstream companies, is a higher proportion of the overall S&P 500. So, if you think about relative performance, we were--and still are--underweight energy. Now, I don't think that there's any sector of the market that is sacrosanct for anybody, including dividend investors.

Now, it'd be kind of hard to have a portfolio of high-yielding stocks that didn't have staples or didn't have utilities. But you don't need energy; it has to carry its weight like anything else. And for me, I like that long-term total-return prospect of Chevron; I certainly like that 4% yield that I think is highly reliable. They have a very strong balance sheet, still plenty of financial strength as well as production growth coming on-line over the next couple of years.

But there is an additional role that oil stocks can play and that is that it's a dangerous world and we don't know that something might happen in the Middle East that might just tremendously disrupt the supply of oil and lead to a price shock. Owning an oil stock, especially one that is a good company that will create shareholder value over the long run, pay big dividends and grow them, that also gives you exposure to the value of the resources that they have in the ground in a future price shock, I think that plays a valuable role as a hedge for just about anybody as long as they are a consumer of oil.

I might say almost all of us, unless we're off the grid living in a cabin in the woods somewhere, we're short oil, we're short natural gas, we're short these energy commodities that we need to consume. So, I think that as unpredictable as the oil price and the natural gas price often are, there is still a hedge quality that continues to make these stocks appealing--[or at least appealing enough] to have a decent position in a stock like Chevron in a long-term income portfolio.

Glaser: Josh, thanks for your thoughts.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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