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1 Green Flag and 1 Red Flag for Passive Income Energy Stocks

The energy sector is benefiting from strong oil and natural gas prices, a massive green flag for energy producers. The industry, where the largest names are renowned for their big dividend payments, is a tempting option for investors seeking out passive income. This sector, though, is known for its volatility, which can materialize in quick and dramatic price changes. Here's a look at the green flag supporting dividend-paying energy stocks today and the one factor that could quickly turn green into red. Essentially, you need to be careful about the stocks you pick here if you are looking for a reliable dividend stream.

High oil prices lead to multiple positives

In 2020, efforts to slow the coronavirus pandemic led to a steep drop in demand for oil and natural gas. Prices fell along with demand, resulting in a painful downturn for energy stocks. ConocoPhillips (NYSE: COP), a pure-play energy producer, fell 38% that year, but was down more than 60% at one point. The drop isn't surprising, given that ConocoPhillips lost an adjusted $0.97 per share in 2020, down from a profit of $3.59 in 2019.

But this deep industry downturn helped to set up the current upturn, since it resulted in a material drop in capital investment throughout the energy sector. When demand came back, more quickly than some had expected, there was a mismatch between supply and demand that pushed oil and natural gas prices higher. Then geopolitical tensions rose, further exacerbating the supply shortfall. There's nothing that looks likely to materially alter these dynamics in the near term.

Improved performance driven by high oil prices allowed ConocoPhillips to pay both its first-quarter regular dividend of $0.46 per share and declare a third-quarter variable return of cash payout of a huge $0.70 per share. Meanwhile, Shell (NYSE: SHEL) recently announced that second-quarter results would be robust and that it increased the value of assets producing oil and natural gas by $4.5 billion, reversing earlier write-downs. Until high oil prices start to materially retreat, ConocoPhillips, Shell, and a host other dividend-paying oil stocks will continue to prosper and be able to send that passive income to shareholders.

There's always a downturn eventually

The problem with this story over the long term is that it's just a matter of time before something in the currently positive environment changes, making things tougher for energy companies. The energy sector is highly cyclical, and upturns are invariably followed by downturns. The biggest threat today is likely a recession, which would lead to another reduction in demand. And even if the drop isn't as bad as the one experienced during the early days of the pandemic, the impact would still be lower prices and reduced earnings for dividend-paying energy stocks.

ConocoPhillips' variable dividend policy could fall all the way to zero in a recession, even if it manages to maintain its regular base dividend. If reliable passive income is your goal, keep in mind that the big payouts of right now won't be in place forever. And while Shell is likely to support its dividend through the next industry downturn, dividend growth might be out of the question.

Notably, ExxonMobil (NYSE: XOM), after years of annual dividend increases, held its dividend flat at $0.87 per share per quarter throughout 2020. That said, the company's decades-long streak of annual increases remains intact because the dividend was increased in the middle of both 2019 and 2021. Which speaks to the sagacity of focusing on large, financially strong energy stocks with a proven history of producing passive income.

The concern about a recession is material because central banks around the world have been increasing interest rates in an effort to slow inflationary cost increases. High energy prices are, in fact, a part of the inflation problem. So in some ways, central banks are actively looking to make oil prices fall. It would likely be a mistake to extrapolate high oil prices too far into the future, which means you need to think more cautiously when you are looking at passive income options in the oil and gas space today.

Be ready for the downturn

The ups and downs here aren't new; the energy industry has always worked this way. The problem is that investors seem to forget that what goes up eventually comes down. And when the down does arrive, dividend-paying stocks can find it hard to cover their payouts. ConocoPhillips' variable dividend policy, for example, is specifically designed to result in lower dividend payouts during the lean years. With oil prices strong today, it might be a good idea to err on the side of caution and stick with the largest and strongest names (Shell and Exxon both fall into that category), particularly if you are trying to create a reliable passive income stream.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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