ConocoPhillips COP DividendConocoPhillips (COP) is one of the biggest oil producers in the world and the newest case study regarding the dangers of chasing yield (the stock had a dividend yield of 7.7% as of yesterday evening).


Despite its $45 billion market cap, $2.4 billion in cash on hand, and single-A credit rating, COP slashed its quarterly dividend from $0.74 per share to $0.25 per share, representing a 66% reduction. The stock’s yield just fell from 7.7% to 2.6% (using yesterday’s closing stock price of $38.63 per share), and a theoretical $10,000 investment in COP will see its annual income generation drop from about $770 to $260.


Even worse, income investors that chased COP are sitting on another 2% capital loss this morning as the stock has traded off on the news (COP is down 18% YTD). Chasing yield is a dangerous game, and dividend investors need to remember that we are still playing a total return game where income and price matter. To avoid riskier dividend stocks, income investors might be interested in reviewing our earlier article reviewing how to find safer dividend stocks.


Fortunately, we did not own COP in any of our dividend portfolios because it had one of the lowest Dividend Safety Scores in our database with a score of 17 (scores of 50 are average, 75 0r higher is excellent, and 25 or lower is risky). To better understand the safety of a dividend payment, we believe prudent investors must look at a handful of key metrics, including a company’s payout ratios, free cash flow generation, cyclicality, and balance sheet.


As a commodity company, COP required extra scrutiny. Commodity companies are notoriously capital-intensive, often carry high debt loads to fund their operations, generate less predictable free cash flow, and have little to no control over the selling price of their products.


If these businesses overextend themselves during peak operating conditions (e.g. taking on debt to fund major growth projects, acquire a competitor, or repurchase), they can be in for a world of pain when their markets inevitably but unexpectedly cycle down. The timing is almost never good.


With the oil market, this is exactly what happened. OPEC (Organization of the Petroleum Exporting Countries), the largest and lowest-cost group of oil producers, decided to flood the market with supply to take market share back from higher-cost North American shale oil producers. Tepid demand and a flood of incremental supply is a recipe for disaster in any commodity market and oil has been no exception, falling over 70% from its 2014 peak.


No one knows when oil prices will recover or the price they will recover to. However, higher cost producers with extended balance sheets and less diversified businesses are feeling the noose tighten around their necks.


Why did COP have to cut its dividend? Let’s take a closer look at the company’s financials.


Through the first nine months of 2015, COP generated approximately $6 billion in operating cash flow. The company’s capital expenditures totaled $7.9 billion over this period, resulting in a free cash flow drain of about $1.9 billion. COP also paid out about $2.7 billion in dividends during this period. Once dividends are added in, COP’s cash flow drain reaches $4.6 billion through the first nine months of 2015.


When a company is burning through cash, it will not be able to survive longer term unless it either (1) has a boatload of cash reserves on the balance sheet; (2) improves its profitability or capital efficiency; (3) issues equity; (4) issues debt; and/or (5) sells off assets, which only goes so far.


In the case of COP, its cash on hand ($2.4 billion) isn’t enough to even cover the amount of dividends it paid out and is hardly above the $1.9 billion free cash flow loss the company reported.


Profitability improvements also appear unlikely because COP’s margin is mostly impacted by the price of oil. The company is slashing its spending and working hard to reduce its production costs, but the 70% drop in oil prices is hard to offset, especially depending on the quality of a company’s oil reserves and the regulatory environment it operates in. Furthermore, COP is more impacted by lower oil prices because it has no downstream operations after it separated from Phillips 66 (PSX). Downstream businesses are performing very well in this environment and providing a bit of a cash flow hedge for integrated producers such as ExxonMobil (XOM).


With little cash on hand and operating cash flow unable to even cover capital expenditures, much less the dividend, COP needed to sell off non-core assets and tap debt markets to keep the game going.


COP did issue $2.5 billion in debt through the first nine months of 2015, but its balance sheet was reaching increasingly dangerous levels. As seen below, COP had nearly $25 billion in debt compared to $2.4 billion in cash. In 2014, the company only managed to generate $1.25 billion in free cash flow, or about $1 for every $3 in dividends it paid out that year.


COP Dividend Credit

Source: Simply Safe Dividends


At some point, banks become less willing to lend to distressed businesses, especially on favorable terms. However, companies will always make interest expense and debt principal payments before paying a dividend.


In COP’s case, we can see that reducing the dividend would free up several billion dollars in cash flow each year, which the company could desperately use during this period of distressed oil prices. Poor cash management, weak cash flow generation, excessive leverage, and dependence on unpredictable commodity prices ultimately drove COP’s dividend cut.


Despite the turmoil impacting energy markets, we actually own two oil companies in our Conservative Retirees dividend portfolio. Unlike COP, however, each of these businesses generated positive free cash flow in 2015 (even excluding asset sales) and have much better production cost profiles and diversification.


While practically no oil company’s dividend will be safe if $30 oil prices persist for the next five years, we expect these two producers to be some of the last ones standing if it comes down to that (we don’t expect it will).


For investors seeking safe dividend stocks, reviewing some of our favorite blue chip dividend stocks and the lists of dividend aristocrats and dividend kings are good places to start. And remember – high yields are more often than not high for a reason, especially with cyclical, indebted commodity stocks.