Shell Shock

Not, perhaps, the most original title to this note but apt, nonetheless.

Yesterday (Thursday) Shell ‘shocked’ the markets with the announcement that they would cut their dividend by two-thirds.  This, of course, is the first cut since World War II.  The cut was not entirely unexpected but it still managed to send shock waves through the market.

The big oil companies are huge payers of dividends (Shell is the first oil major to cut, the others: BP, Chevron and Mobil have maintained dividends but are more likely now to follow suit).  Indeed, such cuts will bring the dividend policy of the oil sector in line with the market as a whole.  Why, though, is this news that we should greet positively?

Simply, the almost perfunctory annual dividend policy is out of step with economic realities. Oil companies need to retain cash to invest in alternative sources of clean energy rather than engage in financial engineering to grow their dividends.  Given the possible (and likely) link between Covid-19 deaths and pollution, governments are bound to take an ever harsher stance against pollution.  Oil companies need to position for the future.  The dividend cut by Shell is not temporary – it is part of the “reset” of the dividend policy.

Also, the present crisis has seen a precipitous drop in demand, whilst the spat between Russia and OPEC has been a perfect storm for oil.  Perhaps, the demand for oil shall never reach previous peaks.  Whatever the future outcome, the inference is that, as investors, we should no longer depend on Big Oil to finance our spending.

It is likely that, in cash terms, dividends will halve this year because of the present crisis.  Indeed,  I suspect that we shall have to become accustomed to the new world of lower pay outs from companies – for several years the yield gap between equities and bonds has been too high (suggesting that either equities were too cheap or payouts too large).  I rather hoped that it would be the former but coronavirus put paid to that…

What does this mean for investors?  Simply that income from a typical portfolio shall drop, sharply.  There is help at hand, though.  There are a number of investments that are likely to maintain their dividends at previous levels for a while (although over time such dividends are bound to decline); this will give short-term respite.  

However, over the longer term we must become accustomed to the fact that, with interest rates at near zero, income from any form of savings is going to be low.  The longer-term solution is to grow capital (companies that do not pay out large amounts of cash as a dividend can reinvest and grow their assets) and use capital profits to supplement income.

I write this note following a few weeks of positive investment returns with equity markets advancing some 20% from their recent lows.  This seems far too high (odd comment for an investment adviser to make).  We are on the precipice of a deep recession.  The coordinated government response might, yet, keep us from the abyss but let us not be fooled into thinking that equity markets know the answer.  It is my opinion that investors are being far too optimistic in the assumption that economies shall recover quickly (a V-shaped recovery). 

Perhaps it is time to sell in May and Go Away Stay Home.

Andrew Longbon

For, and on behald of, Longbon & Company