Energy companies have a spotty history when it comes to paying a sustainable dividend. Many slashed or eliminated their payouts during the industry's last downturn to stay afloat. That trend has continued in recent years because the sector has been slow to bounce back.
Two companies where the risk of a cut seems high is master limited partnership (MLP) Summit Midstream Partners (NYSE: SMLP) and oil giant Occidental Petroleum (NYSE: OXY). Here's why investors should be careful with these two high-yielding energy stocks.
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A worrisome funding gap could yield another cut
Summit Midstream Partners currently yields a jaw-dropping 24%. That sky-high payout comes even though the MLP slashed its distribution by 40% earlier this year. While that reduction helped improve the company's distribution coverage ratio, Summit has other financial problems it needs to address. Those concerns have pushed its unit price down more than 50% so far this year.
One of the biggest worries is that the company owes its parent $303.5 million by the end of next year to pay off a previous acquisition. It's not clear how Summit will come up with those funds. The company can't issue new units without significantly diluting its existing investors since its current market cap its less than $400 million. Meanwhile, it doesn't have much room to borrow more money, given that its leverage ratio was at an elevated 4.8 times debt-to-EBITDA at the end of the second quarter. That's well above the sub-4.0 times comfort zone of most MLPs.
In addition to that, Summit recently formed a joint venture with oil giant ExxonMobil (NYSE: XOM) to build the Double E pipeline. Summit will own 70% of the project -- which will transport natural gas in the Permian Basin -- while Exxon will hold the other 30%. Given that split, Summit will need to fund $350 million of the $500 million price tag. That's a significant amount of money for a company that doesn't have much financial flexibility.
Summit Midstream is pursuing non-core asset sales and other financing options to help bridge its funding gap. However, it still might need to eliminate its distribution in the near-term. Doing so would free up those funds to pay down debt and invest in expansion projects so that it's in a stronger financial position when Double E comes online in 2021.
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An aggressive acquisition puts the dividend at risk
Occidental Petroleum has one of the highest yielding dividends among oil producers at 7%. The company's yield has risen significantly this year due to a 25% decline in its stock price as a result of its controversial acquisition of rival Anadarko Petroleum.
Occidental Petroleum wanted to buy Anadarko so badly that it outbid Chevron by $5 billion. That's on top of the near 40% premium Chevron offered for Anadarko. The company thus had to secure high-cost financing to pay for the cash-heavy $38 billion deal. That added a significant amount of debt to its balance sheet, which is weighing on its stock price.
Given the added interest expenses, Occidental doesn't currently expect to generate enough free cash flow to cover its dividend until 2022. That's assuming oil prices don't slump, which would put its cash flow under even more pressure.
Occidental is taking steps to reduce this financial burden by selling assets. It agreed to unload Anadarko's African assets in an $8.8 billion deal with French oil giant Total. It's also reportedly shopping its stake in Anadarko's former MLP, Western Midstream. If the company can get a good value for the $10 billion to $15 billion in assets it aims to sell, and oil prices cooperate, then the dividend should survive. However, if oil market conditions deteriorate and future asset sales don't move the needle, then it might need to cut the payout.
Steer clear of these high-yield stocks for now
While Summit Midstream and Occidental Petroleum currently offer enticing yields, those payouts aren't on solid ground at the moment. It seems likely that Summit will need to eliminate its distribution within the next year, given that its financial needs far outstrip its current resources. Meanwhile, Occidental Petroleum needs oil prices to cooperate so that it can maintain its dividend while it chips away at the mountain of debt it took on to acquire Anadarko. That's why investors should avoid these high-yield stocks right now and consider stronger ones instead.
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This article was originally published on Fool.com