Are Your Oil Stock Dividends at Risk?

Don't look now, but crude oil prices have fallen again. The price of oil just slid below the $30-per-barrel mark for the first time in 12 years, and there are few bottom-pickers in sight.

Analysts have cut their forecasts for the price of oil in recent weeks. Barclays recently downgraded its forecast for West Texas Intermediate crude oil to average $37 per barrel this year, down from a previous estimate of $56.

"Some of the key bearish catalysts hitting the market include the uncertainty of how much oil Iran may push onto the market, the continued strong production seen out of OPEC and the notable broad market weakness seen in China, which consumes 12 percent of the world's oil," says Mike Ciccarelli, stock and commodity trader at Chicago-based Briefing.com.

None of this paints a positive picture for the majority of energy-related companies, and it leaves questions about the safety of their dividends.

Many yield-hungry investors have looked to high-dividend-paying energy stocks in an effort to boost income in the near-zero interest rate environment of the last seven years. But oil investors have already been hit with dividend cuts in recent months, notably by Marathon Oil Corp. (ticker: MRO) and Kinder Morgan (KMI). And there could be more to come.

Energy companies have slashed dividends, as the dramatic drop in crude oil prices deeply impacts bottom-line revenues. "The situation is very serious in most of the energy complex. At least the refiners seem to be faring fine. But we do need to brace for some rough times ahead," says Hilary Kramer, editor of the GameChangers stock newsletter.

"From drill to pipeline, maintaining the dividend simply isn't a mathematical option for dozens of large-cap oil companies that paid out more last year than they earned. With the credit windows closing, the cash just isn't there. We're going to see a lot of dividend cuts," Kramer says.

There's hope for energy investors. Take heart: The carnage in crude oil prices and in the oil stock sector doesn't mean investors should completely jump ship. "The key for investors concerned about dividend safety is to look for companies with healthy balance sheets, consistent free-cash-flow generation and the ability to tap the credit markets if necessary," says Kelley Wright, chief investment officer and portfolio manager at IQ Trends Private Client Asset Management in Carlsbad, California.

As investors sift through the sea of red in the oil stock sector, there are two issues to consider: how well energy companies are prepared to deal with continued lower oil prices, and how well they are prepared for capital markets that have effectively shut their doors to all but a small handful of energy companies, says Roger Conrad, co-editor of Energy and Income Advisor, published by Capitalist Times of McLean, Virginia.

"Kinder Morgan didn't cut its dividend by more than 75 percent last month because it had bad assets. It cut because it couldn't access capital markets on anything approaching economic terms needed to put an estimated $21 billion of low-risk, high-return energy midstream projects into service over the next three to five years," Conrad says.

Commodity markets tend to move in big supply/demand-driven cycles. Eventually, crude oil prices will move higher. While investors wait, analysts say investors should consider the quality of the companies in the sector and choose those that will pay dividends while you wait. Here is a look at several analysts' top picks now.

Energy stocks to buy or hold. Exxon Mobil Corp. (XOM) is the best of the major integrated oil companies, Wright says. "The company consistently generates positive free cash flow and a high return on invested capital. Perhaps most important is that XOM has a rock-solid credit rating; just one of three companies with a triple-A bond rating, which means excellent access to liquidity."

Another top pick from Wright is Schlumberger (SLB), which he calls the best for oil service companies. "The balance sheet is in good shape with healthy debt ratios, and the company has been a consistent generator of positive free cash flow. Both companies have long histories of outstanding dividend growth, averaging a minimum 10 percent annual dividend increase for the prior 12 years, Wright says.

Kramer says ConocoPhillips (COP) is a top energy dividend pick because it "has room in its margins to theoretically survive on its current dividend."

Meanwhile, Ciccarelli urges investors to shy away from the dividend approach, but he highlights other potential energy plays. "I believe dividend cuts are something investors need to remain scared of; there are no oil and gas plays that I would buy into if I was seeking income, for now. There are a few safe names, but even safe names sometimes become overcautious. For now, I want to give the oil market more time before I look into energy plays as yield plays," he says.

"For straight capital appreciation, my favorite oil and gas plays for 2016 are QEP Resources (QEP), Pioneer Natural Resources (PXD) and EOG Resources (EOG). They have strong balance sheets, strong drilling property locations and impressive drilling efficiency," Ciccarelli says.

Among master limited partnerships, Conrad recommends Dominion Midstream Partners (DM) and Shell Midstream Partners (SHLX). "Both have a low cost of capital, supportive parent/general partners that are committed to dropping down high-quality midstream assets to these partnerships, strong balance sheets and a clear path to annual distribution growth of 15 percent plus through 2018, without having to sell stock or bonds into a market that doesn't want to buy energy," he says.

"We look for more downside in energy prices this year, probably well into the $20s due to oversupply. But at the end of the day, it's asset quality that will differentiate winners from losers in a low energy-price environment that will likely last several years," Conrad says.

Kira Brecht is a financial journalist who writes extensively on stock, commodity, and foreign exchange markets, investing strategies, the economy and the Fed. She was managing editor at SFO (Stock, Futures & Options) Magazine for 10 years, creating digital magazine, newsletter and online content aimed at the individual investor. She began her career on the floor of the Chicago futures exchanges covering commodity markets for a financial newswire service. Follow her on Twitter @KiraBrecht.