Business models can make huge differences in performance, even for companies that operate within the same general industry. That is exactly the conundrum that dividend investors have to deal with when considering Pioneer Natural Resources (PXD -2.28%) and Enbridge (ENB -1.21%), two large North American energy companies. Here's what you need to know before buying either of these two stocks.
Some big, unreliable dividend numbers
The energy industry is generally broken down into three broad segments: upstream (drilling), midstream (pipelines), and downstream (refining and chemicals). While some companies have exposure to all three areas, others focus on just one.
Image source: Getty Images.
Pioneer Natural Resources is an upstream company that produces oil and natural gas in the U.S. market. The prices of oil and natural gas basically drive the company's top and bottom lines. Drilling is a very volatile business given the often dramatic and swift ups and downs in energy commodities.
The coronavirus pandemic highlighted this risk: A demand decline during the economic shutdowns used to slow the spread of the illness briefly pushed West Texas Intermediate crude prices, a key U.S. energy benchmark, below zero. That situation quickly turned around, however, with oil prices rocketing higher when economic activity picked up again.
Pioneer, meanwhile, has instituted a variable dividend policy tied to financial performance meant to allow investors to share in the upside. The dividend rose from $0.55 per share per quarter in 2020 to $8.57 per share in the third quarter of 2022.
But investors benefiting on the upside also have to feel some pain on the downside. For the past three quarters, that dividend has been shrinking, and it now sits at $3.34 per share per quarter (which is still a substantial figure). And it could keep sinking, especially when you consider that a drop in oil prices from $80 per barrel to $60 would reduce the company's free cash flow by more than 50%.
So when dividend investors look at the huge 11.5% dividend yield associated with Pioneer, they should take it with a grain of salt. Yes, they will see huge dividends when energy prices are high, but they can't count on them lasting -- and the yield really doesn't tell the whole story.
Slow and steady
Enbridge, meanwhile, operates in the midstream sector, owning a large portfolio of infrastructure assets that help to move oil around North America and the world. These assets are vital to the global energy system and would be difficult if not impossible to replace. The key difference here, though, is that Enbridge charges fees for the use of the assets. So demand for energy, which tends to remain resilient even during energy price declines, is more important than energy prices.
That creates a very stable stream of cash flows to support the company's dividend, which helps explain how Enbridge has managed to increase its dividend annually for 28 consecutive years. The business model is basically built from the ground up to support a reliable and slow-growing dividend.
Add to that the company's investment-grade balance sheet and distributable cash flow payout ratio of roughly 65%, about the middle of the company's target range, and there appears to be no reason to worry about a dividend cut. But don't expect huge growth. Most of the return here will come from the dividend yield, not from price appreciation. Investment opportunities in the midstream sector aren't as material as they were a decade ago.
The winner is...
For dividend investors who want to rely on the passive income their portfolios create, Enbridge will probably be the better choice. That's not to suggest that Pioneer is a bad investment, just that it isn't designed to provide consistent dividends.
However, that could work out for investors looking for an offset to energy price variability they may personally experience in the form of gasoline and heating costs. With Pioneer, your dividends will likely be heading higher at the same time you are being asked to pay more at the pump. While that might sound attractive, it requires a certain mindset to sit tight with a stock that rises and falls with energy prices just like its dividend does.
In other words, Enbridge is the play-it-safe option that most will likely prefer.
