Nothing is more compelling to investors than a high-yield dividend payment. Heck, if you told me I could buy a company with a steady dividend yield of 5%-6%, but that the share price won't budge, I would gobble that up any day of the week. Problem is, many energy companies sport high dividend payments, but those payouts are built on shaky ground. For some, their very industry is not conducive to supporting a steady dividend payment. Let's check out three segments of the oil and gas industry with questionable dividend records, along with what makes those payouts a less than sure thing.
Any upstream master limited partnership
Generally speaking, investors buy into master limited partnerships because they provide a high-yield income stream, which shareholders hope will mean relatively stable, growing payments over time. (Dear Internet, I know this isn't the case for everyone on the planet. Just run with it.) The trouble is that when you are selling commodities such as oil and gas -- which have been subject to wild price swings for decades -- it can be extremely difficult to predict a stable, growing amount of cash flow from which to pay those exorbitant distributions.
Oil and gas producing MLPs could do some conservative budgeting, such as exercise hedging contracts on every hydrocarbon they produce. Today, that sounds like a great idea, and companies in the space are making those very sorts of moves. Linn Energy (NASDAQOTH:LINEQ) just announced that over 80% of its oil output this year already has a set price through hedging contracts to protect cash flow for 2015 and preserve what remains of a distribution that has already been cut this year.
The problem with this strategy is that when commodity prices rise, investors' memory loss kicks in and they clamor for less oil and gas to be sold using futures contracts to reap the benefits of higher prices. As soon as management falls victim to this pressure, it seems the next price drop is right around the corner, soon followed by a distribution cut.
Here is the one bright side of a royalty trust: you don't have to worry about the threat of bankruptcy. This is because royalty trusts aren't companies. They don't carry debt, they don't have operating costs, and they don't have to invest in the future. All you own with a royalty trust is the mineral rights on a certain parcel of land; as long as oil and gas are coming out of the ground you get a royalty payment each quarter.
The upside here is also the downside: this is not a company. So you don't get the benefit of reinvestment back in the business for future growth. You don't have a management team that can slow production when commodity prices are low to reap the benefits at some later date. Once the oil and gas stops flowing from that particular patch of land, that is the end of any royalty payments.
This means two key things. First, an investment in a royalty trust is always in perpetual decline. The hope is that the royalty payments over time will generate a sufficient return for you before it runs out. Second, without management in place to write futures contracts or control production output, the royalties on that oil are completely at the whim of oil and gas prices and can fluctuate wildly from year to year. This is not exactly the position you want to be in if you are seeking stability from that dividend payment.
Offshore rigs (at least when they had big dividends)
This one is almost a gimme because what were once huge dividends are now quite modest. If you look at the dividend yields of most offshore companies today you would wonder why they are considered high. But a quick look at what has happened to those dividends in the past six months shows why they were once considered such high-dividend plays.
- Nov. 26, 2014: Seadrill (NYSE:SDRL) suspended its dividend and plans to use the $2 billion in annual cash flow savings to pay for several rigs that are under construction and pay down some debt.
- Feb. 16, 2015: Transocean (NYSE:RIG) cut its dividend by 80% to preserve cash flow and maintain its investment-grade credit rating. Savings from the dividend reduction will help fund 12 new rigs being built.
- Feb. 26, 2015: Ensco (NYSE:ESV) also slashed its dividend by 80% to save over $500 million annually in dividend payments that can instead be used to pay down debt and fund its newbuild program.
You can see a general theme here. Most of these companies were trying to have their cake and eat it too by paying hefty dividends while embarking on ambitious growth plans to meet the growing needs of offshore oil and gas production in the deepest water we can drill at today. While this type of oil production will be needed over the long term, it is also some of the most expensive, and these are the first projects to be cut when oil prices collapse. With a business model tied to high oil prices, these companies' dividend payments are bound to look sketchy when demand for their rigs dries up.
What a Fool believes
This isn't necessarily saying the companies operating in these spaces are bad investments. Some are very compelling long-term plays on the energy industry, and I even own some of them personally. However, based the very nature of their business models in the energy space, their high-yield dividend payments are not the most stable, and not something to count on through thick and thin. If you intend to invest in these companies over the very long haul, then you might be on to something based on when you buy; but if you're looking for a steady income check, look elsewhere.
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