My Philosophy On Long-Term Oil Investing

Royal Dutch Shell pays out a dividend of $0.94 per quarter, or $3.76 per year. The price of the stock currently sits at $69.83 per share, an inch above the company’s fifty-two week low price of $68.29 that was reached during Friday’s trading. I find it to be a chronically underrated company, with annual returns of over 14% from 1914 through 2014 and over 11% annual returns since having globally scaled operations in 1986.

It is also a company that has served an important purpose in helping me develop and improve my overall understanding of investing, as Royal Dutch Shell had cut its dividends six times over the course of delivering 14% annual returns during the past century—the story of long-term oil investing success is one of peaks and valleys, with each decade’s peak being larger than the one reached during the previous business cycle. Because commodity prices fluctuate, often abruptly and with little discernible warning in advance. Where companies like Coca-Cola, General Mills, Colgate-Palmolive, and Hershey reliably grow profits annually for every nine years out of ten, oil stocks have a business model guaranteed not to do this.

This tendency comes with both an advantage and a disadvantage. As a matter of behavioral investing, there is usually an overreaction—the price of oil stocks falls more than is warranted by the decline in oil prices as investors use recency bias and project recent news far out into the indefinite future (it was a mere six years ago, a blink of time in the scheme of things, that we were debating the constitutionality of excess profit tax legislation on the supermajor oil companies for making too much money!).

And when the price of oil, natural gas, and other commodities stays depressed for an extended period of time, dividend cuts become a possibility (heck, Royal Dutch Shell is probably the third most conservative energy investment someone could make, behind only ExxonMobil and Chevron, and it has averaged a dividend cut every sixteen years from the dawn of the First World War until the present time). This often induces massive selling, particularly among income investors, at precisely the time when the stock is cheapest and the paper losses become cemented into permanent losses. Other times, investors initiate a position in an oil company with a long-term time horizon in mind, and somewhere during a significant fluctuation—be it, 40%, 50%, or 60%, find themselves unable to handle the momentary loss of significant capital and decide to sell.

Of course, these destructive impulses can be fought. If you study the company balance sheets of the six oil majors, you will see vast resources to the tune of billions of barrels of oil in reserve and trillions of cubic feet in natural gas that will almost assuredly make these companies solvent and highly profitable enterprises for many decades to come. Furthermore, because the long-term demand for oil and natural gas among industrializing nations and nation-states is growing at a rate in excess of the rate at which the supply of these resources is being produced, I find it intelligent to expect the long-term price of commodities to rise by one to three percentage points above inflation over the coming decades, even if the yearly movements do not smoothly indicate this larger trend that is at work.

Now, for the advantage that accompanies volatile energy prices: the reinvestment of large dividends at lower prices. When you buy something like Colgate-Palmolive, the reason why you outperform is due to a high internal rate of compounding and reinvestment at a tolerable price that allows you to lock into more shares that can also lay claim to Colgate’s high internal rate of compounding. It is the business performance of the company that is propelling your returns. With oil companies, the earnings per share growth tends to be lower, but you receive a very significant benefit from high payments that get reinvested into discounted shares. Someone will look back on BP dividends reinvested at $39, Shell dividends reinvested at $69, Chevron dividends reinvested at $108, Exxon dividends reinvested at $93, and Conoco dividends reinvested at $67, and smile. The lagniappe provided to investors by the reinvestment of high dividends at lower-than-fair-value prices does not become apparent until years after the fact, such as when a private investor reviews old brokerage statements of reinvested oil share dividends in 2008 and 2009 and compares them to the current value today.

Speaking of which, I think part of the reason why you are seeing fear among oil investors today is caused by investors that neglect to take a moment and contemplate the almost incomprehensible vastness of the oil majors. Even with oil prices down, BP still makes $14 billion in annual profits. Even with oil profits down, Royal Dutch Shell still makes $18 billion in annual profits. Coca-Cola, the ubiquitous symbol of a truly global brand, meanwhile earns $9 billion per year. Keeping mind such vastness makes easier to recognize the price declines as a pricing opportunity. To get an idea of how much money flows through the business, I offer this fact: Royal Dutch Shell generates more than $400 billion in revenues per year, even with the current low prices of oil.

During the worst of the financial crisis, Royal Dutch Shell’s yield reached 6.5%. Right now, it is at 5.4%. During eight out of the past ten years, the starting yield for Shell investor was somewhere in the 4% range. We are now at a point where someone buying Royal Dutch Shell today is likely to achieve 10% annual returns from here, with over half of that total return coming from the dividend. Production growth of 3% or so annually, plus (dare I say it?) a long-term rise in oil and natural gas prices should make that the case. The only difficulty presenting itself to investors is that owners of the Royal Dutch Shell B shares cannot automatically reinvest into more B shares—they would have to make an independent purchase order to buy more shares of the oil giant. This is not the end of the world, as Royal Dutch Shell rarely becomes overvalued, and you can combine B share dividends with fresh cash to treat the company as something on your permanent buy list.

I imagine that buying and holding five of the six oil majors now (I exclude Total SA because the French dividend tax takes a significant bite out of total returns and holding the stock is not necessary when you have a portfolio already stuffed with Exxon, Chevron, Conoco, BP, and Shell), holding the shares through thick and thin, and reinvesting the dividends when possible, will lead to very significant amounts of annual income ten to twenty years from now. Of course, if the volatility bothers you, there are other things you can do—Nestle, Unilever, and GlaxoSmithKline appear like good deals, for instance—but for those who like good discounts on stock purchases and recognize the value of reinvesting dividends at depressed at depressed prices, the next few years should likely be focused on building out the energy component of your family’s portfolio.