Danger Lurks for These 3 High-Yield Energy Stocks

By Markets Fool.com

Image source: Getty Images.

Continue Reading Below

Today's low-interest-rate environment -- in which safe investments like savings accounts, CDs and government bonds offer paltry yields -- forces investors looking to boost their income to take on more risk. However, some risks just are not worth the potential reward. Consider, for example, Alliance Holdings GP (NASDAQ: AHGP),Summit Midstream Partners (NYSE: SMLP), andDCP Midstream Partners (NYSE: DPM). While all three of these energy companies currently offer yields of around 10%, there's danger ahead that could result in thesecash distributions heading lower in the future.

Not much security in the forecast

On the surface, it would seem that Alliance Holdings GP's nearly 10% yield is on solid ground: The general partner estimates that it will receive $33.4 million in distributions from its coal producing MLP, Alliance Resource Partners (NASDAQ: ARLP), on a quarterly basis this year, which is just enough to cover its roughly $33 million quarterly distribution to investors. The concern, however, is for 2017 and beyond, when the coal MLP's secured coal commitments fall off dramatically.

For 2016, Alliance Resource Partners has essentially sold out its estimated volumes at a range of 35 to 36 million tons. That will enable the company to generate enough cash flow to cover its distribution at a two times coverage ratio. Next year, however, it only has secured commitments for 24.3 million tons, with steeper declines to 15 million in 2018 and 7.9 million in 2019. If the coal market does not vastly improve and new sales contracts don't materialize, the company's revenue and cash flow will decline, which could force the company to cut its distribution again, in turn leading Alliance Holdings GP to cut its payout as well.

Don't overlook the refinancing risk

Continue Reading Below

Midstream MLP Summit Midstream Partners'current yield is an eye-catching 10.2% that, likewise, appears to be on solid ground. Currently, 98% of Summit Midstream Partners' revenue is fee-based, and that stable cash flow supports its cash outlay with ample room to spare, as is evidenced by the company's 1.25 times distribution coverage ratio last quarter.

However, the company has significant financing risks to address over the next few years. First, as of the end of the second quarter, it had borrowed $721 million of the $1.25 billion available under its revolving credit facility. As a result, short-term debt made up more than half of its total outstanding debt. While the company recently raised more than $125 million through equity sales to pay down debt, it needs to refinance more of it, which could be costly, given its junk-rated credit and the current weakness of the energy market. Also, the company recently completed a $1.2 billion asset drop down with its parent company, which included a deferred payment of $800 million to $900 million to be funded by 2020. The structure of that transaction allowed the company to "pick its spots" to refinance the IOU. However, while that reduced its financing risk, it did not eliminate it entirely. If conditions deteriorate, the company might need to cut its distribution to lower its cost of capital, not only to refinance that deal but to fund its more than $500 million in organic growth projects.

Hedges are rolling off

Midstream MLP DCP Midstream Partners'also has a current yield of around 10% that it can amply cover with current cash flow. Last quarter, for example, its coverage ratio was 1.06 times, and coverage averaged 1.21 times over the past year. That said, distributable cash flow declined 9.2% last quarter due in part to its hedging contracts rolling off.

Additional hedges will expire over the next year. Because of that, the company's direct exposure to commodity prices will increase from 10% in 2016 to 18% in 2017. While it plans to offset some of that by completing expansion projects to increase its fee-based margin from 75% to 80%, there's a risk that weak commodity prices will cut into distributable cash flow to the point where the distribution is no longer sustainable.

Investor takeaway

Let me be clear: It does not appear that there's any risk of Alliance GP Holdings, Summit Midstream Partners, or DCP Midstream Partners cutting their payouts in the near term. However, all three have potential problems lurking in the future that could cause them to cut their distributions. Because of those risks, investors should not bank these high yielders maintaining their current cash distribution levels for the longer term.

A secret billion-dollar stock opportunity
The world's biggest tech company forgot to show you something, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Alliance Resource Partners and DCP Midstream Partners. 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.