Royal Dutch Shell (RDS.B), one of the largest oil and natural gas companies on planet Earth, cut its dividend after decades of supporting it through good and bad markets. The move shocked dividend investing circles, with concerns that it would lead to a wave of cuts in the energy space. Although that hasn't happened yet, it pays to err on the side of caution. Here are two better dividend stocks from the energy space that are paying investors well and are conservatively financed.
1. The giant with the best foundation
When it comes to investing, diversification is a huge benefit. It's one of the reasons why you would want to own an energy company with a global portfolio of assets spread across the energy sector, from the upstream (drilling) area to the downstream (chemicals and refining) space. Shell, which trimmed its dividend 66% in early 2020, was one of a small collection of companies that offered just such diversification. That was clearly not enough to save dividend-focused investors from a big cut, however. U.S.-based peer Chevron (CVX 0.14%) is a better option.
Like Shell, Chevron has a large and diversified energy business. However, it takes a very different approach when it comes to its balance sheet. Shell has historically carried material debt and a large cash balance, similar to other European energy companies. Chevron carries a low level of debt and a more modest cash balance. For example, at the end of the first quarter, Chevron's financial debt to equity ratio, at roughly 0.24 times, was lower than any of its closest peers'. The two approaches aren't interchangeable.
When the highly cyclical energy sector turns lower, a company with modest leverage can add debt to provide the cash it needs to muddle through the downturn. Chevron has done this -- it ended 2019 with a financial debt to equity ratio of 0.12 times. A company with a high debt load won't have as much balance sheet flexibility and will likely want to conserve its cash, so using its balance sheet in this way won't be as simple a decision. Chevron's more conservative approach to its finances has helped it create a 33-year track record of steadily increasing annual dividends. There's no guarantee that Chevron can keep that going, but with a conservative, long-term approach and a strong history of rewarding investors, this 5.6% yielding energy giant is one of the best options in the energy patch today.
2. Happily stuck in the middle
There's another way to deal with the energy industry's frequent, and often dramatic, ups and downs. Instead of building a business that is heavily reliant on the price of commodities, build one that is centered around fees. This is what North American midstream giant Enterprise Products Partners (EPD 2.27%) has done. This master limited partnership owns a massive collection of pipelines, storage, processing, and transportation assets. It would be difficult, if not impossible, to recreate its portfolio. With its size and reach, Enterprise is considered a bellwether in the midstream sector.
The key here, however, is that over 85% of its gross operating margin is derived from fees. Put another way, Enterprise is paid for the use of its assets; the value of what is moving through its system is much less important. Thus, the partnership's business tends to be very stable, and even resistant to weak commodity prices. That said, demand shifts can reduce the amount of material it handles, crimping earnings. And low energy prices can lead to reduced investment in the energy sector, which can limit Enterprise's growth prospects. Both are issues today, with a supply/demand imbalance that's left oil trading at very low levels.
However, with distribution coverage of roughly 1.6 times in the first quarter and a financial debt to EBITDA ratio that has long been at the low end of its peer group, the distribution doesn't appear to be at risk today. Moreover, the distribution has been increased annually for 23 consecutive years, showing a material commitment to unitholders. With a yield of roughly 9%, income investors should get to know Enterprise.
It's tempting to reach for yield, forgetting that the underlying business is, in the end, likely to be more important than the dividends it throws off. Although it was something of a surprise to see Shell cut its dividend, Chevron and Enterprise look like they are in very different situations financially and, in key ways, structurally. If you are looking at energy stocks, this pair should be high up on your list.