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Energy Stocks

The Energy Sector’s Endangered Dividends

By Roger S. Conrad, on Dec. 16, 2014

Dividend cuts reduce investors’ current income, erode confidence in the company and drive the stock price lower—a triple whammy that can saddles investors with major losses. And the company that goes down this road risks alienating income-seeking investors who view such a move as a betrayal of trust.

In Conrad’s Utility Investor, my 21-member Endangered Dividends List highlights potential cutters so that you can avoid the sour consequences of buying a stock with an unsustainable payout.

Sweet Yields, Sour Consequences

The price of West Texas Intermediate (WTI) crude oil has plummeted by about $50 per barrel since late June, while prices for oil produced in basins that are further away from key demand centers have dropped even lower.

For example, Western Canada Select (WCS) has plummeted to $38 per barrel, and spot prices for crude oil produced in North Dakota’s Bakken Shale have tumbled to about $50 per barrel.

At these levels, oil prices are considerably higher than they were in late 2009, when WCS sank to $21.27 per barrel and WTI fell to $30.52 per barrel. However, the proximate causes of the late 2008 and early 2009 collapse in energy prices differ dramatically from the supply and demand dynamics that have driven recent price action.

In this environment, shares of energy producers that pay a hefty dividend have sold off precipitously, as investors worry that extended weakness in the prices of crude oil and natural gas liquids (NGL) will weigh on cash flow when hedge books expire.

These companies must choose between cutting their dividend to reflect reduced cash flow and relying on debt to fund the payout and capital expenditures. Cutting the dividend will anger the income-seeking investors that gravitated to the stocks above-average yield, but this unpalatable decision also increases the company’s odds of riding out the storm.

With production costs approaching $50 a barrel, Canadian Oil Sands (TSX: COS, OTC: COSWF) announced plans to slash its dividend by 43 percent and cut its capital expenditures to the bone. But these adjustments may not be sufficient; management’s guidance assumes an average WTI price of $75 per barrel. We’ve rated the stock a Sell in Energy & Income Advisor’s International Coverage Universe for some time.

Canadian Oil Sands may have been the first exploration and production company to lower its dividend, but it won’t be the last. Several other marginal operators have cut their payout in recent weeks—and there’s more to come, especially among the universe of names yielding more than 10 percent.

(Click table to enlarge.)dvd cuts

Investors enticed by the monster yields offered by shares of dividend-paying oil and gas producers must answer two questions:

  • Is the selloff in these names overdone relative to the risk embedded in their underlying business?
  • How much downside remains for these names?

The answer to both these questions hinges on what happens with oil prices in the coming weeks and months. If WTI stabilizes at $50 to $60 per barrel, dividend cuts will still be in the offing. In this scenario, only the threat of bankruptcy would justify lower valuations.

Investors should also remember that every commodity cycle sows the seeds of its reversal. Higher prices are invariably met with conservation, rising use of alternatives and accelerating production. Conversely, the collapse in oil prices eventually will reduce output and boost usage, particularly in China and other emerging economies, where lower prices are a badly needed shot in the arm.

Producers that survive this crisis will recover the losses we’ve seen this year, just as they did coming back from 2008. Until oil prices stabilize, however, these stocks can definitely head lower.

And the pressure on high-yielding oil and gas producers will increase with each dividend cut. Canadian Oil Sands, for example, has given up 36 percent of its value in the less than two weeks since the firm announced its dividend cut.

Fellow cutter Baytex Energy Corp (TSX: BTE, NYSE: BTE) has continued to drop in the week following its announcement, despite giving up more than 60 percent of its value since early September.

The question, in other words, isn’t whether shares of dividend-paying equities are cheap; given the prevailing uncertainty, the risk of further downside remains elevated. Now isn’t the time to be a hero and try to catch a falling knife.

How to Bet on a Bottom

Income-seeking investors should consider major international oil companies such as Chevron Corp (NYSE: CVX) and Total (Paris: FP, NYSE: TOT) that boast bulletproof balance sheets and have the wherewithal to maintain their dividends.

Neither energy giant cut its dividend in the late 1990s, when oil fetched $10 per barrel or when commodity prices collapsed in late 2008. Both companies are winding down major capital spending programs, which should translate into higher production and lower cash outlays.

These companies will also be able to use their balance sheets to take advantage of rivals’ weakness, laying the foundation for future growth.

Chevron and Total’s stocks have lost ground since summer and will retreat further if oil prices continue their swoon. But you don’t have to worry about dividend cuts or something worse.

Investors looking for big yields should consider buying bonds issued by junk-rated producers. We wouldn’t touch Linn Energy LLC’s (NSDQ: LINE) common units right now, even though they’ve shed more than 60 percent of their value since the beginning of 2014.

However, Linn Energy’s bonds due in 4.5 years yield more than 13 percent to maturity and would stand to benefit if the partnership cut its dividend and applied the proceeds to maintaining production and reducing debt.

That is, the outcome that Linn Energy’s unitholders fear the most—a sizable dividend cut—would be bullish for the partnership’s credit quality and the value of its bonds. And Linn Energy can’t pay a dime in distributions to unitholders until it makes good on its interest payments, providing a degree of downside protection. The same goes for similarly situated producers.

Buy bonds and sell stocks? In almost 30 years in this business, I can honestly say that this is the first time I’ve ever given this advice, though my colleague Elliott Gue made a similar call on Chesapeake Energy Corp (NYSE: CHK) at the height of the credit crunch.

Rarely does betting on a company’s survival lock in returns upwards of 13 percent, especially when the odds are so heavily in your favor. For investors who act fast and can see past the current crisis, opportunity is knocking loudly.

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