Don’t Give Up on Oil Income Quite Yet

Are we close to drowning? According to the International Energy Agency (IEA), we are. In its latest oil- market report, the IEA tells us that if Iran adds 600,000 barrels of oil per day to world output the oil market could “drown” in oversupply.
The IEA goes on to tell us that 2016 could be the third consecutive year that oil supply will exceed oil demand. (Allow me to quibble: Supply can’t exceed demand. Every transaction requires a buyer and a seller. You might be unhappy that oil clears at $30 a barrel instead of $100 a barrel, but it’s nonsensical to say that “supply will exceed demand.”) Sounds like oil prices are destined to trend lower.
Not so fast, because we are just as likely to swim as to drown.
If the oil market is marked by anything, it’s volatility. Yes, overall consumption and production of oil derivatives have trended higher over the years, but changes in implied stock and balances can be volatile from month to month. (If you prefer outstanding returns without the volatility, click here.)

And if you really want to see oil volatility in action, simply glance at a price chart of West Texas Intermediate crude oil. A $100 price swing over a few months isn’t beyond the realm of possibilities.

Predicting the price of oil is analogous to predicting the flight path of a butterfly. No one really knows where either will land, so extrapolation is useless.
A drastic decrease in oil supply is as likely as a drastic increase. Production has already throttled back in U.S. shale. Genscape Inc., a U.S.-based research firm, expects U.S. production to drop to 8.2 million barrels per day from its current 9.2 million – an 11% decline –  by the end of the year.
And don’t think the OPEC producers can pump with immunity. Yes, Middle East OPEC producers are the king of cheap production. Saudi Arabia’s production cost is less than $10 a barrel, but that’s not the complete story. Production cost isn’t synonymous with total costs.
Oil revenue accounts for 75% of Saudi Arabia’s annual budget. I’ve seen estimates that Saudi Arabia needs oil priced between $86 and $106 per barrel in order to meet its obligations. Saudi Arabia ran a deficit of nearly $100 billion last year. It will likely run a similar deficit this year. The International Monetary Fund believes that Saudi Arabia could run out of cash in five years if oil stays below $50 per barrel. Don’t expect the Saudis to wait five years.
On the demand side, consumption is expected to hold current levels, if not exceed them. The Manhattan Institute, an economic think tank, expects global oil consumption to rise by 1.3 million barrels a day this year, even with an economic slowdown in China. Consumption will grow on rising automobile demand, particularly in Asia.
I’m convinced that oil is priced closer to a bottom than to a top. I’m also convinced the potential reward many oil companies offer is worth the risk. Dividend yields on many integrated oil giants are near all-time highs.
Exxon Mobil (NYSE: XOM) shares yield 3.8%. The U.S. energy giant continues to raise its payout annually in this trying environment. The United States’ second-largest energy company, Chevron (NYSE: CVX), has backed off from dividend growth for the time being. It has held its annual payout at $4.28 per share for the past two years, but that payout produces a 5.2% yield. It’s highly unlikely either company will cut its dividend, even if low oil prices persist longer than I expect.
If you’re willing to venture out on the risk curve, you can pick up even more oil income and higher yield. I refer to Royal Dutch Shell (NYSE: RBS-A) and BP PLC (NYSE: BP).
Royal Dutch Shell shares (ADRs) yield 9.7%. Royal Dutch is priced for a dividend cut, but the last time it cut its dividend was in 1945. The Dutch energy giant had good reason for cutting its dividend 70 years ago: It was preoccupied with surviving Nazi occupation in the Netherlands.
BP shares (ADRs) yield 8.2%. The British energy giant made news this past week for announcing it would lay off 4,000 employees. This is just one of many steps BP has taken over the past year to cut costs, raise cash, and more important, to maintain its $2.38 per share annual dividend. BP sold billions of dollars worth of assets to raise cash following its 2010 Gulf of Mexico oil spill. It plans to sell $3 billion to $5 billion worth of assets this year, and to sell another $2 billion to $3 billion in 2017.
Both Royal Dutch and BP sit on cash and cash equivalents that exceed $30 billion each. Both companies’ CEOs have reiterated their commitment to their respective company’s dividend. Given their high yields, investors have yet to be convinced they can follow through on their commitment.
(For companies whose investors need no convincing, click here.)
Yes, oil investments are risky in this environment. But I’m convinced that the risk is commensurate with the potential to achieve superior long-term reward.