UK dividends surged 38.6% in the second quarter of 2022, to a near record-breaking £37bn, after a bumper quarter of business for oil and gas companies. With growth slumping and the UK edging towards recession, this sector is gaining investor attention as it benefits from the impacts the Russian/Ukraine war is having on energy prices.
“The west does not want to fund Putin’s war machine with petrodollars, so is trying to switch suppliers as rapidly as possible,” explains Garry White, chief investment commentator at Charles Stanley. “This political positioning has created an artificial supply shock – one that is particularly acute in the European Union, which is highly dependent on Russian gas. Russia provided about 40% of the total to heat homes and power its industry prior to the war.”
This is happening at a time when renewable energy sources are unable to pick up the slack, with droughts across Europe exacerbating the issue. White adds: “This has hit hydropower plants in Norway and has reduced the amount of water for cooling in nuclear power plants in France. This means alternatives are having to limit their output too.”
Gauging how long record can last
Essentially, this situation has gripped energy markets and forced prices higher. With no end in sight to the conflict in Ukraine, this trend is here for the foreseeable. However, long-term investors will naturally want to know if this trend in oil and gas – where billions in excess cash is being generated every quarter – has longevity their portfolios can count on.
This is an issue of debate among investors. Wisdomtree’s Mobeen Tahir, director of macroeconomic research and tactical solutions, points to a potential normalisation of oil and gas prices.
“According to the International Energy Agency’s July Oil Market Report, global oil demand is expected to be 99.2 million barrels per day (mb/d) in 2022. Global oil supply, however, is expected to average 100.1 mb/d in 2022,” says Tahir. “This is because Russian oil has found new buyers after being shunned by Europe and the UK. As a result, the global oil market remains broadly in balance with ample supply available to meet demand this year.”
With commodity prices cooling, the supply/demand bottleneck may also loosen for these companies. Rebecca Palmer, director of ESG at governance and risk consultancy Waystone, is unconvinced of this trend’s long-term viability and points to the growing pressure these companies face.
“Longer term, the winners in oil and gas will be those that can pivot to greener energy production,” says Palmer. “There is an argument these record profits should be reinvested into adaptation and mitigation technologies – since they are no longer being used to drill new wells – rather than paid out as bumper dividends or used to fund share buybacks.”
For this reason, Palmer is unsure about the bumper dividends continuing: “I don’t believe current dividend levels are sustainable as I expect profits will normalise and I believe we’ll see more companies in the sector adopting variable dividends ie, paying out more when oil and gas prices are higher, and less when they are not.”
Others have greater faith in the long-term dividend-paying prospects of these companies. Fairview Investing director Ben Yearsley believes these payouts are sustainable: “They were rebased during covid and haven’t returned to former levels despite the huge free cash flow.
“That’s partly down to share buybacks and also investment plans as well as being aware of politicians windfall tax calls. However, with the ability to rescue debt, buy back shares and invest for a greener future the outlook is good.”
The pressure on oil and gas
Record profits among oil and gas companies are headline news as they are occurring at a time of spiralling inflation in the UK – 10.1% as of July 2022, the highest since 1982 – while the cost of living crisis worsens for many.
This has produced a backlash against energy companies, something politicians are under pressure to side with. This has taken the form of a ‘windfall tax’, as Quilter Cheviot equity research analyst Jamie Maddock explains: “Despite the announced windfall tax being small relative to their cashflow, further windfall tax changes or a new levy are distinctly possible.
“As oil companies are perceived to be beneficiaries of the Russia/Ukraine war that is, in turn, benefiting shareholders – a narrow slice of society – via hefty share buybacks and dividend streams while wider society is being faced with high petrol and diesel prices and/or gas/energy bills. It could be that this societal pressure forces the hands of governments to implement more punitive windfall taxes and thus this could impact on returns for investors.”
Criticisms of corporate greed are not the only ones being levelled at these companies. The rise of ESG investing has brought these companies’ environmental impacts into sharper focus, with pension schemes and fund houses under greater pressure to divest.
Maddock is unsure about how much change ESG could bring about and points to the sheer size of the balance sheets involved – with so much cash on their books, many of these companies can withstand divestment and shareholder pressure.
“These are also businesses that, while we remain heavily involved in fossil fuel extraction, do see themselves as part of the energy mix in the transition to net zero and beyond,” he adds. “As such, while spending may increase, they see that they will subsequently benefit from the demand for renewable energy, technology, and infrastructure.”
Additionally, as White highlighted, renewable energy sources are not yet at a stage where they can fully supplant fossil fuels. The Russian/Ukraine conflict has brought greater attention to Europe’s energy relationships, but Yearsley says forcing through this change will take time and for now oil and gas names can still command their position of influence.
“Government energy policy on many western countries over the past decade has been bonkers, frankly, in respect of a rush to greener cleaner energy,” says Yearsley. “There is no debate about the need to decarbonise the energy system, however the rush to do it, and turn off reliable base loads such as gas and nuclear has been a huge mistake. There is a growing realisation that we will need carbon-based products for many years yet.”