Energy stocks have typically paid higher dividends, yielding 5% or more, and have been an attractive asset for investors seeking income.

Yet investors should not count on these higher-paying dividends since the oversupply of oil has sent energy stocks to all-time lows.

For the first time in 80 years, Royal Dutch Shell (ticker: RDS/A ) slashed its dividend in May in response to the glut in the crude oil supply and the global shutdown of businesses that also curtailed the airline industry .

Meanwhile, Chevron ( CVX ) and Exxon Mobil ( XOM ), two U.S. integrated oil behemoths, stated they would not cut their dividends.

Integrated energy infrastructure stocks with resilient cash flows are priced with hefty dividend yields of 8% to 10% and include Enterprise Products Partners ( EPD ), Enbridge ( ENB ) and Kinder Morgan ( KMI ), says Rob Thummel, managing director and senior portfolio manager at Tortoise Capital in Leawood, Kansas.

"The dividends appear to be secure and are compelling as investors look to replace dividend income as several stocks in other sectors have reduced dividend payouts," he says.

While the higher dividend yields are attractive to investors, more energy companies could reduce yields as the industry faces low demand for an extended period.

Energy investors should examine the balance sheet of an oil company and not prioritize the dividend yield, says Stewart Glickman, senior equity analyst at CFRA Research in New York.

"It's going to be a mix of keep/cut when it comes to dividends, but an energy investor's first stop should be to look at the balance sheet," he says.

There are few energy companies where consensus expectations are for positive earnings over the next 12 months.

"In other words, if you look at the next year – a full year of pandemic – the expectations are that most of these energy companies are going to post losses," Glickman says.

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Companies That Will Keep Dividends

Companies that will keep paying dividends are the ones that have low debt on the books and can tap into existing liquidity , such as cash on hand or credit facilities, to continue paying them, he says.

Another critical factor is when debt has to be repaid.

"If you have more time to go before those large debt milestones become due, that's a good place to be," Glickman says. "In normal markets, a debt milestone is looming, and you just refinance and kick the can down the road. That's still an option for investment-grade firms with a credit rating of BBB- or better, but it's a tougher market for high-yield energy firms."

Energy investors should be concerned about the sanctity of the dividend and focus on companies that stand out from the crowd and preserve their dividend. Those typically have low debt ratios and a long amount of time until the major debt maturities arrive.

"Those two attributes buy a firm time to sustain the dividend while awaiting better days. If one or both of those factors is missing, I'd say the dividends are even riskier," Glickman says.

The decision to pay or cut dividends is "precisely the kind of action that separates" oil stock returns from oil price returns, says Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley business. "This is one kind of management decision that may differentiate winners from losers in certain active strategies."

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Oil Price Impact to Stock Market

Both the broader market and oil prices are driven by aggregate demand, and the strength of the relationship between oil price and the broader market may depend on the U.S. dollar and inflation, Gunzberg says.

While oil supply shocks often provide a hedge against unexpected inflation, it is also a source of return that differentiates oil returns from the broader market. On average in the past 10 years, the MSCI ACWI, a global equity index, gained 0.32% for every 1% increase in oil and lost 0.15% for every 1% drop in oil, for a capture ratio of 2.1. However, the U.S. has a much more attractive capture ratio at 3.9 where the S&P 500 gained 0.35% for every 1% rise in oil and lost 0.09% for every 1% oil declined.

Since oil is priced in U.S. dollars, there is an inverse relationship between oil and the dollar.

"When the dollar rises, not only does oil fall, but the rising dollar hurts international stocks, especially emerging market stocks, with relatively little impact on the U.S. stocks," Gunzberg says. "Bonds were barely impacted by oil with the exception of high yield with an oil capture ratio of 5.9, rising 0.19% with each 1% oil increase."

Oil is uncorrelated to stocks, bonds and gold based on using rolling 36-month correlations with data back to 1993. Correlations change through time with equities and high yield getting as highly correlated as 0.8-0.9 in 2008 and again now with current correlation of oil to equities around 0.7 and to high yield at 0.8, slightly lower than in March, she says. On the other hand, U.S. Aggregate Bonds are consistently uncorrelated with oil, now at -0.1, while U.S. corporate bonds are increasing slightly to 0.4. Gold remains uncorrelated with an average and current correlation to oil of 0.1.

The impact to energy stocks is a higher correlation with a capture ratio of 1.1, meaning the upside is close to the downside, Gunzberg says. For every 1% increase in oil, the S&P 500 energy sector rose 0.49%, and for every 1% drop in oil, S&P 500 energy fell 0.45%.

The S&P 500 utilities and health care were the only sectors to gain with falling oil, increasing a respective 6 and 2 basis points (or 0.06% and 0.02%) with each 1% drop in oil, while real estate stayed even and consumer staples lost just 1 basis point. These four sectors also have zero correlation on average to oil and have remained lowly correlated.

The materials, financials, industrials and communications sectors were most sensitive to oil declines with respective down capture ratios of 20, 15, 14 and 11, and also have respective current correlations to oil of 0.59, 0.68, 0.65 and 0.60, offering less diversification benefit.

"If oil rises again, energy is the most direct choice to rise, but technology, consumer discretionary and materials also have significant upside capture ratios of 45, 41 and 39, respectively," Gunzberg says.

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Strategies for Investors

Even if it appears that oil prices are taking the stock market down, the true reason could depend on many other factors, Gunzberg says. There is typically a larger force at play, like demand destruction from the health crisis .

"Generally, if oil prices are declining and gas prices fall, it is positive for the consumer and the market, and keeps inflation low," she says. "However, if oil prices drop severely and companies are left unhedged, there are bigger issues that may arise, such as credit defaults, energy stock declines and layoffs, that could have more widespread consequences."

Diversification is key in the current environment, including the energy, metals, agriculture and livestock sectors.

"Whether oil is rising or falling, there can be opportunities across large- and small-caps or upstream versus downstream, while bonds have lower volatility than oil with relatively low correlations," Gunzberg says.

Investors who want to maintain oil exposure in a portfolio should move toward integrated oil companies that have a low cost of production and enough cash flow to cover their dividends, said Steve Sosnick, chief market analyst at Interactive Brokers in Greenwich, Connecticut.

Investors should avoid investing in exploration and production firms as well as oil-field services and equipment companies, says David Trainer, CEO of New Constructs, a Nashville, Tennessee-based investment research company.

Instead, focus more on the refiners and integrated oil firms that "take less price risk and serve more as middlemen between producers and consumers," he says.

While Trainer says he thinks dividends for oil companies are in "big trouble," he recommends energy stocks such as BP ( BP ), CVR Energy ( CVI ), HollyFrontier ( HFC ) and Marathon Petroleum ( MPC ).

Investors need to be patient and see through the temporary dip in prices because they will rebound from these excessively low levels.

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