Let me explain. When share prices fall, yields immediately rise. That’s because yield is simply a measure of the dividend amount divided by the share price. So as the share price falls, the yield rises. That happens even if the dividend payments don’t change at all.
Consider one of the biggest energy dividend stocks: BP (NYSE: BP). Back in July – when oil was around $95 per barrel – the stock traded around $53. The $0.585 quarterly dividend translated to $2.35 per year. Given the share price, that resulted in a 4.4% dividend yield.
Six months later, BP yields 6.6%. Now you might mistakenly think that BP increased its dividend by 50%. But that wasn’t the case. So what’s behind the 50% jump in the dividend yield?
The answer is simple. The quarterly dividend has increased less than two cents per share, yet BP’s share price has plunged 32%. As a result, the yield has increased dramatically. That increase is largely due to the drop in BP’s share price.
I love investing in dividend growers – companies that are regularly increasing their dividend payments. But it’s important to recognize the difference between growing dividends and higher yields.
I know that investors are buying up energy stocks today, hoping that oil prices have hit a bottom. And I want to make sure that you don’t make the mistake of chasing yields with energy stocks.
A Bloomberg report showed that more than $3.1 billion was invested into energy stock Exchange Traded Funds (ETFs) in December. That was the biggest inflow since December 2007, when oil was at $91 a barrel.
You may be thinking of buying up energy stocks to capture higher yields. On the surface, high yields can appear attractive. In fact, I looked at energy stocks with at least a $2 billion market cap. I found 17 that paid at least a 6% dividend yield. That included four paying more than 10%: Crestwood Midstream Partners (NYSE: CMLP), Linn Energy (NYSE: LINE), CVR Refining (NYSE: CVRR), and Northern Tier Energy (NYSE: NTI).
But if you’re considering “bottom fishing” for energy stocks, you need to be cautious.
High yields can be a telltale sign of a risky dividend. Last month, I told you about one casualty of lower oil prices. My article – SeaDrill Cuts Dividend: Investors Lose $3 Billion – explained how SeaDrill (NYSE: SDRL) shares plunged 23% in a single day after the company slashed its dividend.
SeaDrill isn’t the only energy stock cutting its dividend. Earlier this month, two Master Limited Partnerships cut their dividends as well. Breitburn Energy Parners (NYSE: BBEP) and Linn Energy (NYSE: LINE) each announced a dividend decrease of more than 50%.
Neither stock reacted much to the news … but that’s because the dividend cuts were already priced into the stocks. Linn Energy shares had already fallen 66% in the last six months. Meanwhile, Breitburn is down 70%.
The decline in oil prices certainly creates an opportunity. I’m looking for bargains. But I’m also being extremely cautious. The dramatic drop in oil prices will have a very real effect on energy company profits.
If you’re going to start buying energy stocks, I recommend focusing on quality. Seek out the highest quality stocks with healthy balance sheets. The next few months will continue to present strong headwinds for the energy sector.
This article is brought to you courtesy of Ian Wyatt from Wyatt Investment Research.