Dividend investors had better beware as they look for top stocks in the oil industry. Some former dividend darlings have responded to the oil price collapse by mercilessly slashing their payouts. Occidental Petroleum just cut its dividend by 86%. Apache, an exploration and production (E&P) company, went even further, cutting its dividend by 90%!

It's not a question of whether there are more cuts coming in the sector, but which company will be next. 

A frowning man stands next to an oil barrel pouring oil onto the floor.

Oil industry stocks have been hammered, which has increased dividend yields. But are the payouts safe? Image source: Getty Images.

How you know a dividend is risky

Companies try as hard as they can to avoid cutting dividends, because announcing a dividend cut usually results in a major hit to the share price. But sometimes there's no choice but to cut:

  1. If the company's free cash flow isn't sufficient to cover its dividend and capital spending, and
  2. The company can't cut its capital budget to free up sufficient cash to cover the dividend, and
  3. It already has a lot of debt on its balance sheet and/or has a poor credit rating, making it too expensive to temporarily cover the dividend by taking on additional debt.

One data point that surprisingly doesn't seem to matter much is whether or not a company has cut its dividend in the past. Apache was one of the few E&Ps not to cut its dividend during the oil price downturn between 2014 and 2017. As a result, it had one of the highest yields among E&Ps. Unfortunately, that meant it went into the current oil price war with a high payout relative to its peers, forcing it to cut that payout all the more quickly. 

All five of the companies below have already announced they're cutting their 2020 capital expenditures by between 25% and 45% to try to maintain their dividends. Almost all have a junk credit rating from at least one ratings agency. And all have seen their share prices collapse and their dividend yields soar in 2020. 

Here are the five major U.S. E&P companies that are among the most at risk of a dividend cut. 

1. Murphy Oil

Murphy Oil (MUR -0.76%) currently has the highest dividend yield of the bunch. Thanks to its 79.4% drop in share price year to date, that yield has soared from below 4% at the beginning of the year to 18.1% today. It also has the worst credit rating of the lot, with a BB+ from Fitch and a Ba3 from Moody's, thanks in part to its $2.8 billion in debt, which is 2.1 times EBITDA, on the higher end of its peer group.

Murphy was already posting negative cash flows in 2019, and operated at a net loss in Q4 2019. With current oil prices far lower than they were in Q4 2019, net losses and negative cash flow are likely to continue. It's hard to see how Murphy sustains its dividend with such gloomy financials.

2. Diamondback Energy

Diamondback Energy (FANG -2.17%) nearly doubled its dividend in 2019, from $0.188 a share to $0.375. It may be regretting that decision now. Shares are down 78.1% so far in 2020, which has pushed the yield up from 0.74% at the start of the year to 4.6% today.

Of these five companies, Diamondback has increased its debt load the most in the last five years. Long-term debt is up 778.2% to $5.4 billion, or 1.7 times EBITDA, also on the higher end of its peer group. The company also lacks a cash cushion: Its $123 million cash pile is only about half of its total annual dividend payout. 

In a statement, Diamondback announced it's not only reducing its 2020 capital budget by more than 40%, but "is prepared to decrease its budget further should commodity prices remain weak." Considering that's just what commodity prices seem prepared to do, one wonders how long it will be until the dividend, too, is on the chopping block. 

3. Noble Energy

Noble Energy (NBL) is the only company on the list that doesn't have a junk credit rating (although its Baa3 rating from Moody's is just one level above junk, and is being reviewed for a possible downgrade). Of the five companies, Noble's share price has dropped the most in 2020, down 81.9%; meanwhile, its yield has risen from 1.89% to 10.67%.

Noble has the biggest debt problem of the group. Its debt of $7.3 billion is not only the highest of the lot, but is also 10.1 times EBITDA, more than four times higher than any of the rest. Worse, its net loss for the trailing 12 months was a jaw-dropping $1.5 billion. Noble has trimmed its 2020 spending budget by 33%, but that's unlikely to do much in the face of such dismal financials.

MUR Chart

These five companies have underperformed in 2020. MUR data by YCharts.

4. Hess

Hess (HES -1.82%) has only posted a single quarter of positive net income since 2015. If that weren't bad enough, the company's shares have fallen 57.2% to date in 2020, while its yield has more than doubled from 1.5% to 3.5%. Negative quarterly cash flow has become the norm, not the exception, and its debt is 2.45 times EBITDA, on the higher end of its peer group. So while it's encouraging to see Hess cut capital expenses by 25%, it doesn't put the dividend out of danger. 

5. Parsley Energy

A year ago, Parsley Energy (PE) wouldn't have had a dividend to cut! The company only reinstated its dividend (at $0.03 a share) in August, and then it announced an increase to $0.05 on Jan. 23. After a share price plunge of 72.2% so far in 2020, and with a 291.8% increase in long-term debt over the past five years, it's worth asking if the company might not find it pretty easy to get rid of its fledgling dividend, or at least cut it back to its initial 2019 level.

An industry to avoid

The mouthwatering dividend yields in the oil patch won't be worth anything if the underlying payouts are cut. And with oil price futures at their lowest levels in 15 years, it's unclear how secure dividends are at any E&P, let alone troubled companies like these. Dividend investors should look elsewhere.