Are 'Big Oil' dividends safe after OPEC's production cut?

OPEC's agreement to cut oil production sent the price of Brent crude oil to $48.80 a barrel on Friday, around 6% higher since news of the deal broke on Wednesday. The rise in the oil price is certainly a positive for 'Big Oil' stocks and their dividend outlooks, sending shares in Shell(LSE: RDSB) and BP(LSE: BP) significantly higher this week. However, the OPEC deal has yet to be finalised and investors have many doubts over whether it could prop up oil prices in the longer term.

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The deal is built on shaky foundations. With oil production set to bounce in from Libya and Nigeria, following recent domestic conflicts, and Iran likely to increase production to near pre-sanction levels, the burden to cut production and give up on market share is mostly placed on Saudi Arabia. And while Saudi Arabia and Iran have become more flexible over production targets, longstanding tensions between the two major oil producers still exist, and a final production figure has yet to be agreed.

And even if OPEC follows through with production cuts, it may not be enough to send oil prices back above $60 a barrel. OPEC's planned production cuts may only help its competitors win market share, as higher prices would only encourage other producers to invest more in growing production. Many analysts estimate that North American shale producers have a break-even price of around $50 a barrel, and think many would increase new drilling activity should oil prices bounce back significantly from the deal.

However, at the very least, OPEC's decision will make hedge funds think twice before making bearish bets against the oil price, and this should cap the downside potential of oil prices in the short- to medium term.

Earnings headwinds

While modestly higher oil prices should reduce the likelihood of dividend cuts at Shell and BP, these two 'Big Oil' companies still face many challenges.

Downstream earnings, which have cushioned the impact of lower energy prices, are expected to come under pressure in the coming months. Although refining margins had widened since the beginning of the oil crash in mid-2014, they've been steadily falling since the summer of 2015. Thus, much of the benefit from higher upstream earnings would be offset by falling downstream profits.

And even with the modest recovery in oil prices, both companies will likely still have a shortfall in free cash flow, leaving much of their dividends being funded through debt and asset sales.

However, the shortfall in free cash flow may not be as severe as their dividend coverage ratios suggest. That's because of the introduction of the scrip dividend option, which offers shareholders the choice to have their dividends paid in shares. Take-up for the scrip option is around 20%-25% for BP and Shell, thus reducing the cash needed to pay dividends by roughly the same amount. One problem, though, is that scrip dividends dilute earnings per share and are therefore typically used only as a temporary measure.

Bottom line

So, although the recent OPEC deal makes it much less likely that Shell and BP would cut their dividends over the next few years, I'm still avoiding 'Big Oil' stocks right now. That's because although the 6%-lus yields may seem safe, there are significant headwinds for earnings.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.