The energy industry currently offers the highest average dividend yield of any sector in the stock market. At around 4%, it’s more than double the S&P 500‘s dividend yield.
Many energy stocks offer even higher dividend yields, making them great for those seeking to generate passive income. However, not all the industry’s big-time payouts are suitable for income investors. Here’s a closer look at two great energy income stocks and one that investors should avoid like the plague.
A big-time payout with more to come
Energy Transfer (ET -1.78%) currently offers a 7.4%-yielding distribution. While higher-yielding payouts are often higher risk, that’s not the case with Energy Transfer. The master limited partnership (MLP) generated nearly $1.2 billion of excess cash after paying its monster distribution in the second quarter. It used that money to fund its expansion program with room to spare. That enabled the company to continue making progress on bringing its leverage ratio down to its targeted range.
Energy Transfer is rapidly approaching its leverage target, enabling the pipeline company to start returning more cash to investors. It has boosted its distribution by 50% already this year. Meanwhile, its ultimate goal is to return the payout to its former peak, implying more than 30% growth from here.
The MLP could eventually exceed that level, given the growth it has coming down the pipeline. Energy Transfer is investing in expanding several natural gas pipelines, export facilities, and other infrastructure. Meanwhile, it has several other growth projects in the pipeline, including an LNG export facility. These projects should grow its cash flow, giving it more fuel to increase its big-time distribution.
Lots of visible growth ahead
Enbridge‘s (ENB -1.82%) dividend currently yields 6.1%. The pipeline giant also supports that big-time payout with a healthy financial profile. Enbridge targets a dividend payout ratio of around 65% of its cash flow and has a strong investment-grade balance sheet. That puts its payout on solid ground and gives it billions of dollars of annual investment capacity.
The company currently has a large backlog of expansion projects under construction, including new natural gas pipelines, natural gas utility expansions, and renewable energy projects. These investments should enable Enbridge to grow its cash flow per share at a 5% to 7% annual rate through 2024. That should allow the company to continue increasing its dividend, which it has done for 27 years.
Meanwhile, the company is starting to line up its post-2024 growth drivers. It’s investing in an LNG export project, a large-scale natural gas pipeline expansion, and an offshore wind farm in Europe that will start entering service in 2025. That positions the company to pay a sustainable and growing high-yielding dividend.
Steer clear of this coal producer
Alliance Resource Partners (ARLP 0.16%) also offers a high-yielding dividend that currently yields 6.4%. That’s after the coal mining MLP gave its investors another raise, this time 14.3% above the prior quarter’s payout. Overall, it has boosted its distribution by 300% over the past year.
The company is currently benefiting from strong demand for coal. Prices were up 25.1% in the second quarter while volumes improved by 9%, helping drive a 60% increase in earnings.
While Alliance Resource Partners can maintain its dividend in the near term, there are questions about its long-term sustainability. The world is rapidly moving from coal to clean-burning natural gas and renewable energy, so its legacy coal business faces an uncertain future. That’s leading the company to start transitioning to other energy sources.
Alliance unveiled its energy transition strategy in the first quarter. It has made several investments, including in an electric vehicle charging company, a developer and manufacturer of electric motors, and a private equity fund that will invest in new energy technologies. While these investments could pay off down the road, they won’t generate cash to support its distribution anytime soon. It could be challenging for Alliance Resource Partners to maintain its hefty distribution as coal demand wanes.
Make sure the high-yielding dividend is sustainable
The energy sector can be great for those seeking a high-octane passive income stream. However, given the energy transition, not all energy companies will be able to maintain their big-time payouts over the long term. That seems to be the case with Alliance Resource Partners, given that coal demand could plummet in the coming years in favor of natural gas and other alternatives. That transition does play into the strategies of Energy Transfer and Enbridge, making them much better options for investors seeking sustainable income streams.