With oil prices sliding and the energy sector ranking as the worst-performing group in the S&P 500 this year, income investors are rightfully concerned about the viability of the sector’s dividends.
Those concerns are amplified at a time when the Energy Select Sector SPDR Fund (NYSEArca: XLE) is yielding north of 9%, which is high by the fund’s historical standards.
Meanwhile, dividend yields on companies like Shell, BP, Exxon Mobil, and Chevron have increased, reflecting a steepening sell-off in the company share prices. While stockholders benefit from the higher yields, some question the companies’ abilities to continue to maintain or hike dividends should oil and gas prices remain stubbornly low and keep earnings under pressure.
If there is a positive for XLE, it’s that some analysts believe integrated oil companies, including Exxon and Chevron can maintain current payouts. That’s good news for XLE investors because those two stocks combine for 49% of the ETF’s weight.
“The spike in dividend yields to all-time highs suggests the market believes a dividend cut for many companies is likely,” said Morningstar in a recent note. “We disagree and think dividends are largely safe, thanks to an ability to increase debt in the near term. Furthermore, companies are likely to slow or stop dividend growth, reduce capital expenditures, sell assets, and if necessary, restore the scrip option to save cash.”
Safe Dividends…Sort Of
Rather than cut or suspend dividends, it appears that many of the world’s largest oil companies will look to reduce exploration budgets and trim or eliminate share buybacks, which are sensible options in the current oil price environment.
Those moves could bolster balance sheets at a time when the sector is increasingly cheap. Valuation may be one reason why. The recent sell-off may have opened up a potential buying opportunity for bargain hunters, especially in the oversold energy sector. The energy sector’s price-to-book ratio is at the lowest level ever while its price-to-sales multiple is at the bottom 6th percentile.
“While we think the probability of a dividend cut is relatively low, it does vary by company, with those with more leverage and higher break-even prices at greater risk according to Morningstar. “Current futures prices for 2020 and 2021 are below what we estimate break-even levels to be for the integrated oils, implying that each company will be unable to fully cover its dividend with free cash flow at current levels.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.