It goes without saying that right now it's a bad time to be Big Oil. The price of oil is down approximately 50% from its peak levels last year. The steep collapse in oil brought most energy stocks with it.
However, the bright side of lower stock prices is that dividend yields go up, because price and yield move in opposite directions. As a result, the good news from oil's crash and the corresponding meltdown in energy stocks is that income investors now have a better buying opportunity than at any point in the past few years.
High-yield energy stocks are everywhere. One of the best is Royal Dutch Shell plc (NYSE:RDS-A) (NYSE:RDS-B), a European oil major with a 5.5% dividend yield. Shell's dividend yield is unusually high right now because its share price has fallen approximately 25% over the past six months.
Shell's tantalizingly high dividend yield is backed by solid profitability, even in this difficult climate.
Big Oil's big advantage
Perhaps the most attractive feature of owning Royal Dutch Shell is its high dividend, which leads its industry. Shell's 5.5% payout towers above Chevron Corporation's (NYSE:CVX), which yields 4.2%, and ExxonMobil Corporation's (NYSE:XOM), which yields 3.2%. These Big Oil members hold integrated businesses that include upstream exploration and production as well as downstream refining.
The benefit of the integrated model is that each side of the business tends to perform better under different conditions. Upstream benefits greatly from high oil prices, because the exploration and production of oil needs a supporting underlying commodity price. On the other hand, downstream business tends to do better when oil price spreads widen, which increases refining profit margin.
With both sides of the business, profits tend to stay afloat even when oil prices collapse like they did last year. For example, Chevron's net income fell 10% last year, due mostly to an 18% decline in upstream profits. However, downstream refining served as an offset. Thanks to stronger refining spreads, downstream profits nearly doubled last year to $4.3 billion. ExxonMobil's profits clocked in at $32.5 billion in 2014, flat with the prior year.
Likewise, Royal Dutch Shell's net profits fell 8% to $15 billion in 2014, which is impressive given the commodity carnage last year. Declining profit is never a good thing, but all things considered Shell's performance is admirable. Shell's earnings were boosted by its large downstream business, which comprises 27% of Shell's total profits. Refining performance improved significantly, and its downstream earnings soared 40% last year to $6.2 billion.
This allowed Shell to generate a high level of cash flow even though oil declined. Last year, Shell generated $25 billion of free cash flow. This was more than enough to cover its capital return program. Shell returned $15 billion to investors through a combination of dividends and share buybacks.
Shell's dividend appears secure
The relatively strong performance of the integrated majors versus other types of energy companies explains why, while several oil drillers and E&P pure-play companies have cut dividends recently, the integrated group has not done that. In addition, Big Oil companies like Shell are so large that they can easily find ways to trim costs and sell off certain assets that are non-critical to the future. Shell completed $15 billion worth of asset sales last year. Furthermore, Shell states that the company has curtailed over $15 billion of potential capital spending over the next three years.
These decisions should help keep returns on capital and cash flow high, even in such a difficult environment of falling oil and gas prices.
Shell generates enough cash flow to sustain its necessary expenditures and also reward shareholders with a high dividend yield. While there are never any guarantees, Shell has a balanced business model and employs strict capital management practices. Because of this, Shell's 5.5% dividend yield appears secure.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.