Pioneer Natural Resources (PXD -2.28%) operates in the energy sector, producing oil and natural gas in the onshore U.S. market. The company has adopted a performance-linked dividend payment plan that leads to higher dividend payments when energy prices are elevated (and lower when energy prices are depressed). So it is important for investors to understand the biggest driver of financial performance, which is, without a doubt, energy prices.
Nothing to be done about it
Pioneer Natural Resources drills for and sells commodities. It doesn't get to set the price of what it sells -- the market does that. This is one of the reasons why oil and natural gas prices tend to be very volatile, often moving dramatically in surprisingly short periods of time. Demand for these key energy sources is also pushed higher and lower by economic activity, which complicates the pricing picture even more, adding a cyclical component.
As oil and prices go up and down, so goes the financial results of Pioneer Natural Resources. Adding to the importance of this fact, Pioneer has tied its dividend payments to its financial performance. There's a base dividend that is expected to be resilient across time that is supplemented by a variable payment that will rise and fall with the company's results.
So while the energy company has a very generous 11% dividend yield today, that number can't be relied on over the long term. Notably, the dividend has been cut three quarters in a row at this point.
And this is where the intersection of energy prices and dividends comes into clear relief. As the graph clearly demonstrates, as West Texas Intermediate (WTI) crude (a key U.S. energy benchmark) rose, so too did the dividend. Similarly, as energy prices fell, so did the dividend.
PXD Dividend Per Share (Quarterly) data by YCharts
Just how important is this?
Pioneer Natural Resources doesn't hide from this fact, and, frankly, the variable dividend shows that it has embraced the inherent variability in the energy sector. Investors buying the stock are clearly in a position to benefit when things are good and share in the downside when things are bad. However, the company has helped to highlight the dynamics here. It should be eye-opening for investors.
Without giving specifics, since oil prices move around a lot in any given quarter, management laid out some broad figures. If WTI crude prices were to average around $60 per barrel, Pioneer believes it would produce around $13 billion in free cash flow over a five-year period.
Dividends come out of cash flow, not earnings, so this is actually a more important figure than earnings for dividend investors. Still, it provides a good idea of overall performance, since free cash flow is, effectively, derived from earnings. The $60 WTI figure is the base case.
The next breakpoint Pioneer provided was $80 WTI, which would lead to free cash flow of $27 billion over a five-year period. So a $20 increase in WTI prices would result in an over 100% increase in free cash flow. That's a massive difference and shows how leveraged the company is to energy prices.
A key piece of that is the simple fact that operating a business comes with material base costs. Once those costs are covered, earnings and free cash flows ramp up pretty quickly.
The top end of the company's free cash flow range shows up with its $100 WTI estimate. At that price, Pioneer believes it would generate $40 billion in free cash flow over a five-year period. This number is a bit lower than you might expect, given the over 100% between $60 WTI and $80 WTI, but it is likely a reflection of variable costs.
As the energy market heats up and investment activity increases, variable costs for things like salary and renting equipment are likely to increase and become a headwind to further free cash flow growth.
But it is the direction and magnitude of the increases overall that investors need to take note of. Higher oil prices mean higher returns, and in a big way.
Note again the magnitude of the dividend increase along with WTI in the chart, and then pay attention to the declines since WTI started to head lower. These examples are presented in an ascending manner, but the math behind the free cash flow estimates works the same on the way down. Thus, the dollar-based examples provided by Pioneer help explain the dramatic dividend changes on both sides of the equation.
Know what you own
If you are looking at Pioneer Natural Resources for its huge dividend yield, make sure you fully understand the risk/reward profile of this company before you buy it. While it is easy to say that energy prices are the key driver of performance and dividend-paying ability, the actual scale of the relationship may not be as obvious.
By providing estimates for free cash flow at various WTI price points, Pioneer is trying to clear up any confusion investors may have on that front. You should pay attention because it will have a huge impact on your dividend payments and investment results.
