Proceed With Caution When Considering This Ultra-Popular Energy Stock

Oil prices have been bouncing around quite a bit of late, but they remain at a fairly high level. That's good news for energy producers like ConocoPhillips (COP 0.39%), where the top and bottom lines are tied directly to oil and natural gas prices. Investors are benefiting, too, from this company's huge dividend, which includes a performance-based "variable return of cash" component. Before you line up to buy the stock, however, make sure you understand just how ConocoPhillips sets its dividend.

Different dividend models

ExxonMobil (XOM 0.39%) and Chevron (CVX 0.57%) have distinguished themselves in the energy sector by providing investors with regular annual dividend increases. Both are Dividend Aristocrats at this point, with hikes in both good and bad markets alike. Notably, they both have modest leverage and use their balance sheets to support their dividends and capital investment plans during the inevitable lean years in the highly cyclical energy sector. Dividend consistency through turbulence is a key selling point for these stocks.

ConocoPhillips is close to the polar opposite of this approach. It isn't that ConocoPhillips is over-leveraged -- its debt-to-equity ratio of 0.38 times is only slightly higher than Exxon's 0.28 times and Chevron's 0.2 times. And well below a heavily leveraged industry name like BP (BP 0.98%), which sits at 0.95 times on this metric. The difference is the way ConocoPhillips views its dividend.

There is a core payment, currently set at $0.46 per share per quarter, that is meant to be steady and reliable. In addition to that payment, though, there's the "variable return of cash" payment, which in the first quarter was $0.70 per share. Essentially, as the company makes more money, it gives more back to shareholders. That's a clear win today, given that adjusted first-quarter earnings of $3.27 per share were notably higher than the $0.69 per share in the same quarter of 2021.

But more numbers are needed to see what's going on. Specifically, in the first quarter of 2020, ConocoPhillips earned $0.45 per share, not even enough to cover the current regular dividend (the dividend two years ago was $0.42 per share and just covered by earnings). These are just a few examples, but they show that you can't exactly count on good quarterly earnings in perpetuity here because oil prices are variable. And thus, you also can't rely on the "variable return of cash" component, either, since the current good times are unlikely to last forever.

The investor impact

To see what that means for dividend investors, it pays to look more closely at the dividend history. The regular dividend has grown regularly since a 66% cut in 2015. That's good news, and similar to what companies like Exxon and Chevron offer. Management deserves credit for building a business that allowed the dividend to go from $0.25 per share per quarter to the current $0.46 per share rate despite oil's volatility over that span. However, if you look at just the core dividend, the yield here is only 2%, well below that of Chevron (3.8%) or Exxon (3.9%).

In 2021, however, as oil prices rebounded from the worst of the pandemic-driven energy downturn, the board created a way to share the company's performance with investors in the form of a variable dividend. Paid in addition to the regular dividend, the company declared a $0.20-per-share dividend in late 2021, a $0.30 per share dividend was declared in Feb. 2022, and the $0.70 per share payment noted above was declared in May. Investors who take the current dividend and annualize it (the normal approach with regular dividend payments) to create a forward dividend yield might assign ConocoPhillips a yield of 5% if they include the variable component. That would be a mistake and set the stage for a deeply disappointing outcome.

That's because, so far, the story of that extra dividend is all to the upside. That's wonderful -- but long-term investors can't rely on this trajectory. In fact, given the historical volatility of the energy market, it's probably best to plan on the extra payment going to zero at some point. That is, after all, the whole point of having a "variable return of cash". It allows the company to reward investors without having to make a permanent commitment to a higher dividend level. And don't forget that during the first quarter of 2020, the core dividend was barely covered by earnings -- how would management have justified an extra payment to the board of directors at that point?

The problem here is that there is no way to know when high oil prices will fall because the driving force is supply and demand. However, it is almost a certainty that, eventually, the energy market will weaken, and ConocoPhillips will reduce the variable component of the dividend.

Be prepared with knowledge

This isn't meant to suggest that ConocoPhillips is a bad investment -- that's far from the case. It is a generally well-run energy company. And, to be fair, the variable dividend is a novel approach that ensures shareholders are rewarded when the company does well, which it certainly is doing right now. But dividend investors who don't understand the nature of the dividend, and the extreme growth it has gone through during the current energy market upturn, may be surprised to find that it can just as quickly go the opposite direction when times get tough. If you prize dividend consistency, Exxon or Chevron would be better options.