Williams Dividend CutWilliams Companies (WMB) had paid higher dividends each year since 2004, grown its dividend by 38% per year over the last five years, and earned most of its income from regulated assets generating “safe” fee-based revenue from long-term contracts.

 

The company had even been in business for more than 100 years, more than proving itself as a durable operator.

 

However, none of that mattered on Monday when the company announced a 69% cut to its quarterly dividend, reducing its payout from 64 cents per share to 20 cents.

 

While Williams Companies isn’t a master limited partnership (MLP), it has many similarities and a 60% ownership stake in MLP subsidiary Williams Partners (WPZ).

 

Williams provides energy infrastructure that connects North America’s natural gas resources to end markets that have demand for natural gas. Williams Partners is a MLP that operates more than 30,000 miles of pipelines that primarily gather, process, and transport natural gas and natural gas liquids.

 

I previously wrote about why I choose not to invest in all but a very select few master limited partnerships.

 

Simply put, MLPs contain a number of risks that I am uncomfortable with, and many of these factors have impacted their dividends recently.

 

According to Bloomberg, 18 of the 57 U.S. pipeline operators that haven’t declared bankruptcy have cut their dividends or stopped raising them in the last year.

 

Williams was flagged as one of the riskiest dividend-paying stocks in our database with a Dividend Safety Score of 3 prior to announcing its dividend cut.

 

A score of 3 indicates that Williams was in the top 3% of companies most likely to cut their dividends.

 

How can this be for what many investors assumed was a safe dividend-paying stock?

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Many pipeline businesses were viewed as invincible by investors, at least prior to Kinder Morgan’s dividend cut last fall. Pipeline operators touted their take-or-pay agreements, long-term contracts, and lack of sensitivity to commodity prices.

 

With high dividend payouts, pipeline companies sounded like sure bets for yield-starved investors.

 

However, we are living in the midst of a once-in-a-generation crash in oil & natural gas prices.

 

As seen below, for example, the price of natural gas has plunged by more than 50% in less than two years.

 

Natural Gas Price (USD)

Williams WMB Dividend Cut

Source: Forecast-Chart

 

The corresponding pain rippling through the energy space is causing a number of unforeseen consequences to many different businesses.

 

In the case of Williams and other pipeline operators, the contracts they have with energy producers aren’t looking as resilient as they previously thought.

 

Depressed oil and gas prices are jeopardizing energy production levels, possibly impairing the economics of large pipeline growth projects, and potentially creating excess pipeline capacity in certain regions.

 

However, there is an even bigger risk that could surface over the next year or two depending on the future path of commodity prices.

 

Deloitte believes more than one-third of pure-play exploration & production companies listed worldwide are at “high” risk of slipping into bankruptcy barring a sharp reversal in oil prices or a major infusion of capital (e.g. convert their debt into equity).

 

Should additional oil & gas producers (i.e. MLP customers) see their financial health further deteriorate or declare bankruptcy, additional pressure will build on the multi-year customer contracts currently enjoyed by MLPs.

 

Courts have already allowed several bankrupt energy producers to break their long-term contracts with midstream pipeline operators, and more could follow.

 

Circling back to Williams’ low Dividend Safety Score, cyclical, commodity-sensitive companies with high levels of debt and inconsistent cash flow generation are often most at risk of cutting their dividends or even going out of business altogether.

 

Unlike blue chip dividend stocks and dividend aristocrats, which grow their dividends primarily as a result of earnings growth, most MLPs need to borrow money or issue new units to continue growing their distributable cash flows since their partnership agreements usually call for all available cash on hand to be distributed.

 

Weak business fundamentals, unfavorable capital market conditions, and high debt burdens are a lethal combination for these types of businesses. During downturns in commodity markets, companies need to preserve capital.

 

In Williams’ case, its balance sheet forced it to make some difficult decisions. The company had $164 million in cash on hand compared to $24.8 billion in total book debt and $2.8 billion in total dividends paid last fiscal year.

 

If credit markets were to tighten up in response to weakening fundamentals in the energy market, Williams would have little ability to continue investing for growth, paying dividends, and servicing its debt.

 

Slashing the dividend immediately freed up more than $1 billion per year in capital that will provide internal growth financing for its MLP subsidiary and help the combined company reduce debt and maintain its credit rating.

 

WMB’s shares actually closed up more than 6% following the dividend cut news and the company’s earnings report. Investors realized the

 

Conclusion

Investors relying on dividends for safe retirement income need to tread very carefully in any energy-related or commodity-sensitive area of the market.

 

Even the areas that are perceived to be “safe” (e.g. pipelines) can be wrought with surprises as companies work through unprecedented industry conditions and manage potentially large debt loads.

 

MLPs certainly provide essential services that will remain in demand for many years to come. After all, oil and natural gas still need to be moved around the country.

 

However, not all MLPs are created equally. Some are much better managed, more conservatively financed, and better strategically located than others.

 

Before snapping up shares of MLPs for quick income, I strongly recommend reviewing the main risks of investing in MLPs and heeding Warren Buffett’s investment advice to stay within our circle of competence.

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