With the price of oil having collapsed from over $100 per barrel to less than $50 per barrel in just over a year, it is unsurprising that oil stocks are finding life rather tough. After all, even a major increase in production or savage cost cuts is highly unlikely to offset the reduced sales and falling margins which have become a staple of life in the oil industry in recent months.
Looking ahead, there is a good chance that the price of oil will fail to mount a sustained comeback anytime soon. That’s because there is little sign of a reduction in the glut of supply which has caused a global demand/supply imbalance to occur and, while reduced capex and exploration spend may impact on supply in the longer term, for now at least sub-$50 oil seems set to stay.
The effect of this is likely to be continued pressure on profitability and, realistically, dividends for a number of oil companies will have to be cut. In Shell’s (LSE: RDSB) case, its current dividend amounts to 122.5p per share, with earnings per share for the current year due to equal 132.3p. This means that Shell is expected to pay out 93% of its profit as a dividend and, looking ahead to next year, its payout ratio is expected to narrow only slightly to 89%.
In the long run, such a high payout ratio is unlikely to be sustainable. That’s because, while Shell is a mature business, it requires constant reinvestment in property, plant and equipment and, realistically, such expenditure is likely to need to be higher than just 11% of profit. Therefore, unless Shell is able to rebound strongly from the recent fall in earnings by posting rapid bottom line growth, its dividend could come under pressure.
This, though, may not hurt the company’s share price. After all, Shell currently yields 7.3% and, while it may be able to pay out such a level of income in the coming months, it appears as though the market is already pricing in a fall in Shell’s dividend. Therefore, even if Shell’s dividend is cut by 20% for example, the company would still be yielding a hugely appealing 5.8%.
Furthermore, Shell continues to offer excellent value for money. It trades on a price to earnings (P/E) ratio of only 12.8 and this indicates that even if the company does cut its dividend, its shares are unlikely to be hit particularly hard. That’s especially the case since Shell has already seen its share price fall by 29% in the last year.
As such, it appears to offer a relatively wide margin of safety, meaning that it remains a top notch income and value play. However, investors expecting a 7%+ yield in perpetuity may be somewhat disappointed unless the oil price starts to rise at a brisk pace.