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Which Industries Are Most Sensitive to Commodity Prices?

Some pockets of the energy sector are more impervious than others.

The following is an excerpt from the video series Dividend-Stock Deep Dive, hosted by Morningstar DividendInvestor editor David Harrell. Watch the full interview

David Harrell: And you know, obviously the energy sector as a whole is not homogenous, and within it, you have different industries that have varying levels of sensitivity to commodity prices. Could you elaborate on that a little?

David Meats: Yeah, absolutely. So, the companies that I follow, the E&P companies, they're the ones that extract and sell the commodity. So, they're selling the commodity price, it's pretty clear if the commodity goes up, and so does their revenue. And that makes them very sensitive to those commodity prices. But if you look at the other segments in the industry--midstream would be an example--that's mainly the pipeline operators that are responsible for transporting the crude from the well site of the refinery. And those midstream pipeline operators take tolls for shipping. So, the revenue there is based on the volume, not on the commodity price. So commodity price goes up in the short run, not much impact on the volume. They're not immune to commodity prices, because the longer the commodity prices are high or low, the more likely it is that the E&Ps will ship more or less, but they're a little set back from the exposure to commodities directly.

And then if you think about the oil-services industry, their business model involves supporting the E&P companies in the drilling process. And the capital that the E&P spend on drilling, that's the revenue for the oilfield-services companies. So if you have very high oil prices for a very long period of time, then eventually the E&P companies will change their capital habits. If oil price is very high, they'll increase their capital and vice versa. So oilfield-services revenues are sensitive to commodity prices, but it's a second derivative, and it takes time to really manifest. 

And then I guess the last portion of the industry to consider is the refiners. The refiners will see higher crude prices as higher input costs, because they effectively buy crude and turn it into petroleum products. They will make a profit based on the spread between the crude price and the petroleum product price. Higher crude prices will be higher input cost for them, but they're able to pass that through, the petroleum product prices will increase as well. So, they're not as sensitive to commodity prices. A big range, but the most sensitive is going to be the E&Ps.

Harrell: That's the reason we're starting to see this trend in the E&P companies toward variable dividends, because of that sensitivity to commodity prices, correct?

Meats: I think that's true. If you're the CFO of an E&P company, then you have a problem because you know the shareholders want to see return of capital. But if you raise up the fixed dividend to provide that return, oil prices being very cyclical--sooner or later, you're going to find yourself in a downcycle, and in that downcycle your operating cash flow probably isn't going to be sufficient to fund that fixed dividend. And that's an awkward situation. You can either cut your dividend, which sends a really unpleasant signal to the market, or you can lean on the balance sheet if your leverage allows it, if you have the liquidity, or you can rely on the capital markets. And really none of those things is ideal. But then the converse situation is to have a low fixed dividend and not take that risk, but then the market will perceive your income potential as lower.

What these companies are trying to do is find a happy medium. Some are doing that by special dividends: When you have the cash flow every now and again announce a surprise one-off payment to the market. The downside there is it's not very predictable or transparent. So, it's questionable whether the market really gives them any credit for doing that. And the other solution is to pay a variable dividend, which involves paying a fixed percentage of your cash flow every quarter, so oil prices are high, you got lots of cash flow, so the percentage of that will be higher, the variable payout to the shareholders will be higher. But then in the lean times when commodity prices are lower, you have lower cash flow, so as you're only paying a smaller percentage of that, you're automatically reducing your payout and protecting your balance sheet during the downcycle.

Harrell: And you think that this approach actually makes sense for the E&P industry as a whole, correct?

Meats: I do. It's pretty clear that the market wants to see this industry return capital to shareholders. I kind of see it as an analogy to the big tobacco industry in the late 90s, after the the master settlement agreement where these companies were saying, "OK, we're in a sin industry, and we're facing a long-term secular decline for our product, but by being disciplined with our capital allocation, we're able to generate substantial cash flows in spite of that long-term secular decline." And the value proposition is clearly no longer growth if you have a long-term secular decline, but the income component can be significant if those companies are capable of generating the cash flow. I think the oil companies are trying to go the same way. They have this problem of trying to figure out how do we show that we have the potential to return significant cash to shareholders but not run into difficult times during the commodity downcycles. I think the variable dividend mechanism makes a ton of sense.

Harrell: And certainly from income-focused shareholders it means, like you said, without it, the dividend rate would probably be low, to be conservative. So this way, they're getting more dividend dollars than they would otherwise without that variable component.

Meats: Absolutely.