3 Reasons Vanguard Natural Resources Could Cut Its Dividend Again

By Markets Fool.com

Vanguard Natural Resources, LLC just cut its dividend by 44%. That comes after several competitors cut their distributions. With the precipitous fall in oil prices since the middle of last year, this shouldn't have been a surprise to anyone. The move will protect what remains of the dividend and support future growth, at least for now. But realistically, you have to ask yourself if one cut will be enough...

Continue Reading Below

All the right reasons
The Motley Fool's Matt DiLallo recently wrote about all the reasonsVanguard made the right move to trim its dividend. The list includes resetting the dividend to a more sustainable level, maintaining prudent leverage by avoiding debt funded dividends, and freeing the company up financially to invest in acquisitions. At the end of the day, it's hard to argue with any of that logic.

Axing the dividend. Source: Public Domain, via Wikimedia Commons.

Indeed, CEO Scott Smith summed it up nicely:

The difficult, but necessary, decision to reduce our common unit distribution was made to address the economic headwinds we face as a result of the dramatic collapse in commodity prices over the past several months.

Continue Reading Below

But some in the industry think oil could linger at low levels for an extended period, with BPCEO Bob Dudley suggesting that, based on historical precedent, oil could wallow around for up to three years.

Opportunity and risk
On one hand, that's three years that Vanguard can work on adding new volume to its oil production profile. And while that's a good thing, there's another side to this story, because Vanguard's business model is about growth and dividends. Dividends being one of the main allures of the stock, even though paying out large distributions can make investing for growth more difficult -- like right now.

To balance these two conflicting goals and the often volatile nature of the energy markets, Vanguard makes use of hedging. That locks in prices for the oil and natural gas it sells, ultimately providing some stability to the planning process.

For example, the company has roughly 77% of its oil production locked in at around $76 a barrel for 2015. That's why management is pretty confident that its distribution coverage ratio will be around 1.2 times this year, despite the fact that oil is currently trading hands below that level.

Brent Crude Oil Spot Price Chart

Brent Crude Oil Spot Price data by YCharts.

But if BP's Dudley is correct about the length of time oil could remain in the doldrums, this year isn't the year to worry about. It's next year, and the year after that. Vanguard has about 45% of its oil hedged for 2016 at around $83 a barrel. It has nothing hedged in 2017.

Growing out of the problem
Now you could argue that Vanguard's recent dividend cut will support its efforts to grow out of this problem. If it can add enough volume at profitable prices, then the drop in oil prices won't be as big of a deal. While that's entirely possible, at this point, the company expects oil production to be flat year over year between 2015 and 2016.

Vanguard has been an astute acquirer in the past, sowing up over $4.5 billion worth of purchases since its 2007 IPO. Historically, the company's goal is to look at around 150 opportunities, do some real digging on 50, bid on around 40 or so, and close between two and eight purchases. On the surface that's fine, but ifacquisitionscome in at the low end it will be hard to make up for falling oil prices.

Moreover, the company has historically issued stock to help finance purchases. That just makes it harder to pay the dividend, potentially offsetting production gains. In addition, the buyer's market Vanguard expects is attracting competition from outside the industry, including hedge funds. That could push prices higher more quickly than management expects and turn this opportunity into a dead end.

And 2016 is essentially when the hedging cliff shows up, since less than half of Vanguard's oil production is covered, and there's none hedged in 2017. Oil accounted for nearly 45% of the company's oil, natural gas, and natural gas liquids revenues last year, so this could be a big issue if something doesn't change. A sustained rise in oil prices would be the best solution, and it would render this concern moot, but predicting oil prices is, well, far more like astrology than science.

There's no reason to expect another dividend cut in 2015 at this point. However, you'll need to watch how oil prices will impact the company's production, Vanguard's hedging activity, and acquisitionsto get a feel for whether or not you need to be concerned about a second dividend cut showing up in 2016. If oil prices remain depressed, and the current hedging cliff remains in play, there's a real possibility that management won't have a choice but to trim again.

The article 3 Reasons Vanguard Natural Resources Could Cut Its Dividend Again originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.