Which dividends are most at risk in the oil sector?

With the price of oil falling from $110 to less than $50 a barrel since last June it's understandable that investors in the sector might be feeling nervous. Relative to the market, the oil sector as a whole has underperformed by 36% over the past six months. But share prices aside, given that blue chips like BP and Royal Dutch Shell pay out chunky dividends each quarter, income investors would be forgiven for feeling particularly vulnerable right now.

Analysts have been sounding alarm bells about this for a while. Last year Morgan Stanley said that dividend cover - a key measure of dividend sustainability - tends to evaporate for many energy firms when oil trades at $70 or less.

In December, JP Morgan analysts admitted that they'd been concerned about the oil majors' lack of free cash flow to cover dividends when the oil price was as high as $100+. They claimed: “If we stay below that level for the foreseeable future, then these dividends will be paid out of debt and balance sheets will be stretched."

Disappearing dividend cover

A look at some of the largest UK traded stocks in the oil & gas production and services sectors reveals that dividend cover was actually pretty high last year. The median cover in our list of 12 stocks (below) is a reasonable 2.4x earnings. Anything less than 1x suggests a company is paying out more than it earns.

Currently, only Tullow Oil - last year's worst performing FTSE 100 stock - carries negative dividend cover. This week the group announced £2.2 billion of write-downs on its assets ahead of its preliminary results in February.

Name	Mkt Cap £m	Yield %	DPS	Div Cover	DPS Gwth % Forecast 1y	% 3m EPS Upgrade FY1
Royal Dutch Shell	126,947	6.08	1.86	1.37	5.16	-3.26
BP	69,685	6.70	0.39	1.27	7.67	-14.7
BG	27,132	2.48	0.31	2.82	7.23	-6.79
Tullow Oil	3,259	3.77	0.21	-1.06	-8.88	-120
Amec Foster Wheeler	2,979	5.57	0.44	1.16	4.45	1.63
Dragon Oil	2,371	5.17	0.38	3.00	21.6	-1.31
Petrofac	2,063	7.34	0.67	2.37	-3.91	-2.53
John Wood	1,987	2.96	0.24	3.26	26.8	0.58
Eurasia Drilling	1,094	8.00	0.92	3.09	-2.58	-0.83
SOCO International*	831.2	-	-	-	-	-22.6
Premier Oil	674.3	2.49	0.050	8.87	24.0	-1.59
Hunting	639.8	4.72	0.31	2.41	-1.80	1.36

*Soco International structures its shareholder payments as a Return of Cash - it paid 22p per share in 2014

Elsewhere, Shell, BP and engineering group Amec Foster Wheeler have the lowest dividend cover at 1.4x, 1.3x and 1.2x respectively. Both BP and Shell have already announced major capex cuts and ongoing asset sales. We'll find out whether those measures are enough to preserve dividend payouts when they report their preliminary results in late January and February.

Amec Foster Wheeler could be more vulnerable. In early 2014 it set out plans to maintain a progressive policy with dividend cover in the range of 2.0 to 2.5x - but that could be a stretch if earnings fall short this year. On the upside, analysts at SocGen point out that that the company only derives 36% of its revenues from upstream capex.

The stock with the highest level of dividend cover is Premier Oil, with a forecast yield of 2.9% and dividend cover of 8.8x earnings. It has already said that $300 million of write-downs are on the way and that development spending is under review.

Earnings downgrades on the way?

Unsurprisingly, all the E&P firms in the list have seen their earnings forecasts downgraded by analysts over the past three months. The deepest cuts have been issued for Tullow, Soco and BP. High yielding engineering services firm Petrofac has also been trimmed back but other support firms ike Amec Foster Wheeler, John Wood and Hunting have so far seen their EPS forecasts remain in positive territory - just.

In terms of dividend forecasts it's only Tullow, Petrofac, Eurasia Drilling and Hunting where analysts are predicting cuts to payouts. But with indications that oil stockpiles are positively brimming, and hence no sign of rising oil prices in the near term, it's likely that further downgrades to both earnings and dividends are around the corner.

Want to learn more about about dividend covers and the other metrics discussed in this article? Feel free to check out our free ebook, How to Make Money in Dividend Stocks, which can be downloaded here.

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