© BP

The oil majors are Britain’s most important dividend payers. Quarter after quarter, you’ll find BP and Shell among the FTSE 100’s top income stocks. Shell has not cut its dividend since the second world war. BP’s record is not as long, but until the Gulf of Mexico disaster in 2010, the company enjoyed an enviable history of uninterrupted dividends.

However, persistent weakness in the oil price over the past two years has led to concerns over the sustainability of these two income stalwarts’ dividends.

Following its acquisition of BG Group, Shell raised the aggregate payout. Over the course of 2016, Shell will now pay about £10.4bn in dividends — a third more than in 2015, and £1.4bn more than the sum of Shell’s and BG’s combined payments last year. This goes a long way to offsetting dividend cuts from other blue chips such as the miners, Rolls-Royce, Standard Chartered and Wm Morrison. The downside is that it means UK income seekers are increasingly dependent on the oil major.

This year, Shell will account for £1 in every £7.50 of UK dividends. Shell’s higher payout, coupled with exchange rate gains, props up the overall dividend yield of the FTSE 100, according to Capita’s latest dividend monitor. For the next 12 months, Britain’s top flight is expected to yield 3.8 per cent. Remove Shell, currently offering a yield of more than 7 per cent, and Britain’s blue-chip index yield falls to 3.4 per cent over the next year.

When it comes to oil, only two questions really matter: is the oil price going to keep rising and, if not, are dividends sustainable?

Both questions have investors divided. Neil Woodford, the fund manager, has long steered clear of the sector given the question mark over dividend sustainability. Fidelity’s Michael Clark is similarly unconvinced, with the wider oil and gas sector one of the largest underweights in his MoneyBuilder Dividend and Enhanced Income funds.

At the other end of the debate sits Alastair Gunn, manager of the equity portion of Jupiter’s multi-asset fund range. He believes the sector could see a re-run of the performance of the mid-to-late 1990s, when the oil price fell to a low of around $10 in 1998 but rose sharply in the following five years. Oil companies’ dividends went from “unsustainable and vulnerable to a cut” to “might be sustainable” to “sustainable” to “likely to grow”.

So, is the oil price going to go up? Passing the $52 mark last week, it has almost doubled from its low in mid-January. Commodity markets are simple beasts — supply and demand fundamentals remain the key drivers of price.

First, demand. Here there’s really only one story: China. The infrastructure investment witnessed in the country over the past decade is unlikely to be repeated, having been sustained at levels that no country in history has ever achieved. This is bad news for the mining and metals industry, as China makes up 50 per cent of all end demand.

In contrast, just 20 per cent of oil is consumed by China and here demand is likely to rise to reflect the lower oil price, with more miles driven and greater car ownership, as China’s middle class grows. Bottom line: China is far less important to the oil industry than it is to miners and its influence is a tailwind not a drag.

As for supply, another key difference between the oil majors and the miners is the willingness of the former to keep cutting capital spending to maintain dividends. The miners meanwhile have, for too long, found “better” uses for capital than giving it back to shareholders, destroying value by paying over the odds on expansion. When commodity prices collapsed, they were left with little choice other than to cull their dividends.

While the oil industry has not been immune to bad acquisitions and poor capital spending, it has not been anything like on the scale of the miners. These companies are slashing costs from maintenance to people to equipment to ensure cash flows cover dividends.

As the oil majors and the big state-owned oil companies cut capital spending, projects won’t be coming on stream as quickly as expected. Remember oil has a natural decline rate of about 5 to 7 per cent a year. The number is much higher for shale oil. You need to see a pick-up in drilling just to maintain supply. The shale suppliers were incentivised to accelerate production as much as they could to offset a lower oil price. But with access to finance now limited, the amount of future drilling is significantly diminished.

Unlike the struggling miners, oil enjoys elasticity of demand. After months of cheap petrol, miles driven around the world are going up. The US summertime driving season is quickly approaching. Indeed, petrol use in the US is expected this year to surpass a previous record set in 2007, while oil demand in emerging market nations is growing fast.

Finally, there’s the impact of supply disruptions in Nigeria and Canada, and the fact that discoveries of new oil reserves have dropped to their lowest level in 60 years.

But if the oil price remains unchanged, are dividends sustainable? The short answer is probably not. As it stands, the oil majors’ dividends are not covered by cash flow and are being paid out of increased borrowings and asset disposals. This is unlikely to change in the coming months, unless the oil price rises.

But both BP and Shell are pulling out all the stops to maintain their dividend. BP is bringing down its costs to live in a world of oil between $50 and $55. Shell has rolled the dice with its BG acquisition, but the company takes great pride in its unbroken dividend record and last week announced plans to “thrive in a ‘lower forever’ oil price environment”. Finally, don’t forget the currency effect. Both BP and Shell declare their dividends in dollars — if we see a step down in sterling, the translation effect will be a big driver of growth.

While we are unlikely to see a world of oil prices passing the $100 mark, the bullish view is for the oil price to keep rising to around $70-$75 a barrel in about three years. That’s a marked appreciation, and one that could see the sector’s dividends go from “unsustainable” all the way back to “likely to grow”.

Maike Currie is an investment director at Fidelity International. The views expressed are personal. Email: maike.currie@fil.com; Twitter: @MaikeCurrie

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