The oil price rose strongly into the end of 2017 and has continued to rise in the first few weeks of 2018. In the fourth quarter, oil averaged USD 61.4 per barrel, which is 20% up on the same period in 2016 (Source: Bloomberg as at 31 December 2017).
Demand up, supply down
There are many reasons for oil’s rebound, but the strongest boost has come from rising demand as the global growth environment continues to strengthen. Demand from fast developing countries, such as China and India, also continues to grow at a rapid pace. At the same time, new disruptions to oil supply (for example, the hurricanes that impacted the US last September) are creating upward pressure on oil prices—particularly as the oil producer’s cartel, the Organisation of the Petroleum Exporting Countries (OPEC), has also given a firm commitment to maintain its supply discipline.
The higher oil price should lead to improving profitability for oil companies listed on the UK market. However, it’s also important to recognise the degree to which costs have been reduced over the last few years. This cost cutting means that both BP and Royal Dutch Shell, for example, should be able to maintain break even profitability at much lower oil prices than was previously possible.
Positive news for dividends?
The improvement in profits means the oil sector can now earn enough cash flow to cover its dividends—payout ratios have declined from record high levels, and we think many oil companies are likely to remove scrip dividends (scrips), as eluded to in their guidance.
Scrips reduce the cash required to pay the dividend as investors may elect to receive shares in lieu of cash. They have been used by oil companies to maintain dividends through a period of lower oil prices, but the scrip process inevitably leads to a higher share count as new shares are issued, thus diluting those shareholders who elect to receive a cash payout.
Scrips are now being actively cut back or buybacks are being used to mitigate the impact on shareholders. BP announced in its third-quarter results that it intends to buy back shares to offset its ongoing scrip programme, while Royal Dutch Shell is also set to cancel its scrip-dividend programme from the first quarter of 2018.
All of which should help support the UK oil sector and provide some positive news for UK equity income investors.
John Baker manages the JPM UK Dynamic Fund. Read more about the fund: