A high-yielding stock doesn’t necessarily make it a good passive income investment.
Concerns about a company’s prospects will drive its share price lower. But if it maintains its dividend, its yield will go up.
However, if doubts about the viability of the business persist, the stock could become a value trap — one that’s over-priced but masquerading as a bargain.
I suspect many investors are currently considering whether Diversified Energy Company (LSE:DEC) meets this definition.
That’s because its yield of 24% is the highest in the FTSE 250.
And since 18 December 2023, its shares are down 14%.
Serious allegations
That was the day on which four members of the United States House of Representatives Committee on Energy and Commerce published a letter outlining concerns about the company’s accounting policies and environmental credentials.
DEC buys existing gas and oil fields, and seeks to extend their useful economic lives. It claims this policy is better for the environment — and cheaper — than drilling new ones.
But the letter claims it “may be vastly underestimating well clean-up costs“.
Also, although they acknowledge they’re lawful, it’s noted that agreements with certain states allow the company to defer up to $2bn of environmental liabilities.
This is said to enable DEC to give “the appearance of profitability on paper“, allowing it to pay “hundreds of millions of dollars” to shareholders. But it’s said to be leaving it with insufficient funds to clean up the wells when required to do so.
The taxpayer would then be expected to pick up the bill.
The company includes an estimate of the cost of its asset retirement obligations on its balance sheet.
At 30 June 2023, these were forecast to be $453m — equivalent to approximately 17% of the carrying value of its wells.
Any requirement to increase the provision would clearly have a major impact on the financial viability of the company.
A more positive view
But despite these concerns, here’s why I’d still buy the stock, if I had some spare cash.
First, the allegations appear to be recycled from a Bloomberg article from 2021. Its journalists visited 44 of DEC’s 69,000 wells and claimed to find significant methane leaks. DEC responded soon after saying it cost $2k to fix all the sampled wells.
Second, its accounts — including estimates of its future obligations — are audited by PricewaterhouseCoopers, the world’s largest professional services firm.
It’s never flagged the issue as being of concern.
The financial statements reveal that since the start of 2022, the company’s permanently plugged 560 wells, at a cost of $6.97m. That’s an average of $12,439 each.
This is well within the company’s stated range of $20k-$25k. The company estimates it will cost $1.69bn to cap all its wells. Discounting this to current values, gives the $435k disclosed in its latest annual accounts.
Third, DEC has won awards from two independent emissions monitoring programmes for the transparency of its reporting.
And finally, according to the company’s latest report on its well closure programme, it will be debt-free within 10 years.
This is a significantly shorter period that the average life of its wells, which is estimated to be 50 years.
It will then have more cash available to cover any additional financial liabilities or penalties that might arise from the current investigation.
