Some Perspective On The Investor Hysteria In The Oil Sector

Even though I completely understand why investors find dividend cuts unpleasant, I hold the opinion that it is incredibly self-destructive to sell a profitable company after a dividend cut because it is almost assured that the price of the stock has fallen and you would be engaging in the practice of selling low. My opinion on this is intensified when it comes to commodity investing. Outside of, say, Exxon and Chevron, dividend cuts in the sector are fair game. You can grow production of oil and oil equivalents all you want, but if the price of the commodity falls 40%, 50%, 60%, it is unlikely that the company will generate the cash flow to keep the dividend payment stable.

What do many novice investors do in response to a dividend cut in the oil sector? They sell. I think this is a decision that will cause permanent financial loss (as well as emotional pain) in the long run because eventually, oil prices rise again—profits go up, the dividend rises aggressively in the years following the profit gains, and the investor is left banging his head on the table wondering why he chose to sell. Also, the fundamentals of the company aren’t nearly as bad as the media portrays them to be.

Since Benjamin Graham said that it is better to talk about specific examples than to philosophize in the abstract, let’s talk about Ensco. Most people probably haven’t heard of it—it’s only a $5 billion company—but it is well known to people that invest in commodities stocks. It is an offshore contract drilling company, which means that it makes jackups and deepwater rigs that facilitate other companies that have to dig deep into the earth’s oceans to get their hands on oil. When the price of oil goes down, some of these ultradeepwater projects cease to make sense—there are places in the ocean you’d be willing to go for oil that could be sold at $120 but you won’t go after if it can only be sold at $60—so companies like Ensco provide less equipment when the price of oil is low.

Because of the decline in oil since this past summer, Ensco has seen its profits decline, its dividend get cut, and the share price tumble as well. To survey the current state, here is what happened: compared to a price of $65 per share in 2013, Ensco currently trades at $24 per share. The dividend, which had been rising every year since 2009, suddenly cut its $3.00 dividend annually to $0.60 annually. Based on the online forums (fora?) that I have read, many people have elected to sell their Ensco because the price decline and dividend cut proved too substantial.

This bothers me because these people, many of whom are honest and hardworking and have the simple goal of saving money for their retirement or financial independence so that they can spend their lives doing whatever they want, have cemented a decision that will guarantee a financial loss. When you see your net worth seemingly evaporate quickly, it is your job—and your financial future depends upon this—to react rationally and coldly appraise the situation at hand.

You have to ask yourself—what is the big picture with Ensco? If you look at the balance sheet, you will see that Ensco is going to make $1.17 billion in profit this year if the status quo remains. A billion! The people who sold this stock are thinking in terms of declines—this is a company that made $1.4 billion in 2013 and saw the 21% drop in profits—and assumed the company is crumbling. No, that’s not what the numbers show—Ensco isn’t even experiencing a bottom of a cycle that is causing to lose money. Put another way, 2015 will be the fourth most profitable year in Ensco’s existence, trailing only 2008, 2013, and 2014. Yet, people see the falling share price and the dividend cut, and turn off the rational part of their brain and switch to sky-is-falling mode. The stakes are high, because you will destroy your life if you act like this way.

In 2006, Ensoco was making $700 million per year. If someone told you that energy prices would fall during the back half of 2014 and Ensco would emerge from that making around $1.1 billion, you’d probably take that deal because Ensco is emerging from the bottom of the next economic cycle in a stronger position than it had during the moderate highs of the previous oil cycle. There is an interpretation gap, caused by the share price fall and dividend cut and relative lower profits of the past three years, that have caused people to completely neglect the fact that this company is making over $1 billion in net profit this year.

In a few years—it might take three, it might take six—the price of oil will increase and many new projects will be announced for Ensco. The stock price will rise quickly in advance of these expectations (the Wall Street adage about the stock market being a leading not lagging indicator comes to mind) and eventually the dividend will rise quickly when the company benefits from the rise in profits. Just look at how the $0.10 annual dividend in 2009 turned into $1.08 in 2010. The people who sold at $24 will not only have to deal with the setback of selling at the low, but will also have to deal with seeing headlines years from now about the company’s advancing stock price and dividend hikes. You should manage your estate in a way that avoids this fate.

Originally posted 2015-03-03 11:36:29.

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