As interest rates hit historic lows, many investors piled into high-yield energy stocks for yield believing that the U.S. energy revolution would keep dividend payments increasing.
The crash in oil prices has put cash flow in danger and high debt loads from the heady acquisition days is weighing on balance sheets. Share prices have tumbled, sending yields on some energy plays to 10% and higher.
But dividends are being cut to protect cash flow and investors are being trapped into stocks with huge losses and without the yield they were expecting.
Is your favorite energy stock about to make the announcement? Learn the warning signs and check out two names that may be in trouble.
Energy Companies Are Bleeding Cash As if last year's selloff in oil was not enough, the price of West-Texas Intermediate (WTI) has fallen 20% since the end of the third quarter and broke $36 a barrel recently. For the fourth quarter, energy companies in the S&P 500 are expected to post a 34% decline in year-over-year sales and a staggering 65% drop in earnings.
Many in the space have already begun protecting cash by cutting dividend payments or reducing capital expenditures.
E&P giant Chesapeake Energy (NYSE: CHK) decided in July to save $240 million a year by cutting its dividend payment. Shares tumbled 19% over the four days following the announcement and have fallen another 47% since then.
Investors have argued that pipeline MLP companies could escape the pain of lower oil prices since much of their revenue is based on volume instead of prices. The argument got its biggest test earlier this month as Kinder Morgan Incorporated (NYSE: KMI) slashed its dividend 75% and saw shares drop by more than 6% in after-hours trading. Shares had already fallen 31% over the eight days before the announcement.
Investors do not have to be left in complete shock when more companies join the infamy of a dividend cut. While no measure is a guarantee of dividend safety, look for clues within two financial statement fundamentals.
Watch the payout ratio for traditional companies or the distribution coverage ratio for MLPs. The payout ratio is the percentage of earnings used to pay dividends, usually on a twelve-month basis. The distribution coverage ratio is the amount of distributable cash flow (DCF) an MLP has over its distribution.
As of September 2015, the average payout ratio for energy companies in the S&P 500 was just over 80% on a trailing twelve-month basis. This is well above the 10-year median of 25% for the group and really shows the level of risk in payouts. The average distribution coverage ratio for estimated 2016 cash flows among the 50 MLPs covered by Bank of America Merrill Lynch is 1.2 times though 30 partnerships have coverage ratios below the average and eight will fail to cover their distribution with cash flows.
Does the company you want to invest in have positive direction in free cash flow or at least some room to cut capital spending? Free cash flow is the amount of cash made from operations minus spending for investment and capital and is a good measure of the company's cash generation power. Cutting investment spending isn't optimal because it could choke off future growth but it may allow the company to protect the dividend until oil prices rebound.
Two Dividends On The Edge And A Safety Play A 15.2% yield on Colombian producer Ecopetrol (NYSE: EC) is in danger. The annual dividend has already been cut in each of the three prior years and the situation has only gotten worse. The dividend of $1.04 is 173% of estimated 2015 earnings per share and next year's earnings may not be much better with expectations of $0.75 per share. Free cash flow has sunk by 60% to $1.2 billion over the last year with three consecutive years of reduced capital spending. The company has been able to minimize dividend cuts by issuing debt, now at 52% of the capital structure, and cut investment spending but may not be able to protect cash payouts much longer.
Even the major producers like Chevron (NYSE: CVX) might not be immune from dividend cuts. Chevron's annual dividend of $4.28 is outpacing estimated 2015 earnings by 128%. Earnings are expected higher next year but will still not cover the dividend payment. Free cash flow has plummeted to negative $10.3 billion over the last year though the company still has $31.7 billion in capital expenditures it can cut. While Chevron will likely cut capital expenditures, dividend growth may be disappointing and future revenue may be put in jeopardy.
But not every energy company is in trouble. Suncor Energy (NYSE: SU) actually increased its dividend per share in July and has increased it every year since 2011. The current dividend of $0.88 annually is 68% of trailing earnings with expectations for an increase in earnings to $1.40 per share in 2016. Free cash flow has fallen sharply to $675 million over the last year but the company is still spending $4.8 billion in capital expenditures. Suncor has just 27% of the company financed with debt and $4.0 billion in balance sheet cash.
Risks to Consider: The energy space has already been widely sold and it's difficult to forecast share price direction. Valuations are starting to look attractive but even the strongest balance sheets may be in trouble if oil prices stay low for longer.
Action to Take: If you are investing for yield in the energy space, make sure you are watching balance sheet and cash flow data to avoid seeing your dividends cut.
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