One of the best ways to avoid financial risk in your life is to stay out of debt. That’s not always possible, given the cost of houses, cars, and education, but the less leverage you have, the more financial flexibility you’ll have. This same statement is true for businesses. That is why ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) have been able to navigate the energy patch while rewarding investors with decades of annual dividend increases.
No good options
Suppose a company uses leverage to finance an acquisition. This debt appears on its balance sheet, and the increase in interest charges appears on the income statement. What if the purchase doesn’t go as planned or the main business starts to falter? The answer is that the debt and interest charges associated with the deal endure while the top and bottom bottom lines suffer.
The lender doesn’t care that management made a mistake; he always wants to be paid. This can quickly put the business that borrowed the money into a tailspin, with few desirable choices to keep the business afloat. Too much leverage is one of the most common reasons a company ends up in bankruptcy court. This is why investors should always consult a company’s balance sheet to assess the level of debt and the income statement to determine interest coverage.
It gets a bit more complicated for energy stocks since the industry itself is very cyclical. High oil prices can generate strong profits, while low prices can generate lots of red ink. Obviously, it is easier to manage interest and debt problems in good markets. These are the bad markets investors should think about first, as even well-positioned companies may not be able to fully cover interest costs. Exxon and Chevron are probably the best prepared of their similarly managed integrated energy counterparts for the next downturn.
Chevron’s debt-to-equity ratio is around 0.17 times today, which is low for just about any company. Exxon’s ratio is still a fortress of 0.26 times. The next closest integrated energy peer, Shellis 0.44 times, TotalEnergies arrives at 0.53 times, with PB pulling the rear at 0.79 times. But remember, these are the good days.
When the going gets tough, energy companies tend to rely more on their balance sheets to help support their capital investment plans and dividends. For example, during the energy market downturn in 2020, Exxon’s leverage ratio peaked at around 0.4x and Chevron’s fell to 0.33x. The European peers in this pair saw much higher levels, with BP again lagging behind with a peak leverage ratio of more than once.
Here’s the interesting thing: BP and Shell both cut their dividends in 2020 as they looked to reset their businesses and increase their exposure to the hot clean energy space. You could say that the energy transition was the driving force behind the cuts. But the truth is, even without having to pay for costly activity changes, the pair would have struggled to invest in core operations. The dividend cut freed up cash for their capital expenditure needs.
Although Exxon and Chevron did not change their business approach, they also did not need to cut their dividends because there was plenty of room on their balance sheets for the debt they added. To be fair, TotalEnergies announced a similar clean energy pivot and did not cut its dividend. However, its dividend yield rose higher than that of Chevron or Exxon at the start of 2020 because investors feared it was too leveraged.
Note that both Chevron and Exxon are dividend aristocrats, having raised their annual dividends through thick and thin for more than three decades each. TotalEnergies’ dividend record just isn’t as good. The strong financial strength of Chevron and Exxon has been instrumental in their ability to consistently reward investors.
Solid as a rock
To be fair, integrated European energy companies tend to hold more debt and more cash, with their US counterparts Exxon and Chevron opting for lower debt and less cash. But it’s not the same thing. When times are tough, it’s much easier to rely on a balance sheet with less leverage than to use emergency cash and add even more debt to a heavily leveraged balance sheet. Chevron and Exxon are simply better positioned to weather the ups and downs of the energy sector, and their fortress balance sheets are a key factor. If you are interested in energy action today, first think about what will happen when things are not as good as they are now. In this scenario, Exxon and Chevron should do very well.
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Reuben Gregg Brewer holds positions at TotalEnergies. The Motley Fool fills positions and recommends BP. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.