Dividend Opportunities in the Energy Sector: Navigating Risks and Rewards

peachgardenpartner
Mar 2
7 min read

By Milo Goldstein

Executive Summary

The energy sector, currently undervalued by 6.8%, presents opportunities for income-focused investors despite volatility caused by fluctuating oil prices, geopolitical uncertainty, and the global energy transition.

Macro Overview

Broad energy ETFs such as XLE and VDE have shown promising year-over-year

growth, while more sector-specific ETFS such as IEZ have underperformed.

Economic Developments

The Federal Reserve’s “higher for longer” stance reduces the potential for a

smooth clean energy transition in the US, in contrast to the anticipated ECB’s rate

cuts which make EU energy investments more attractive.

Dividend Stocks to Watch

Alliance Resource Partners (ARLP) has stood out with its 10.54% dividend yield,

promising cash flow coverage, and attractive valuation. European energy ETFs

such as EXH1, as well as clean energy ETFs such as INRG offer diversified

growth potential.

Risks and Opportunities

While commodity price volatility and dividend sustainability concerns are present,

attractive valuations, as well as the energy transition present great opportunity.

Investments into the energy sector also serve as an affective hedge against

inflation.

Forecasts and Projections

Global economic growth and moderate inflation are likely to support the energy

sector, however the forecasted decline in oil prices may apply some pressure to

the sector, specifically towards upstream companies.

Macro Overview

Key Indicators at a Glance (25.02.2025) – Dividend Focused ETFs

Indicator	Latest Value	Previous Value	YoY Change (%)
XLE - (Broad exposure to energy sector)	89.72	82.62	+8.59%
VDE – (Broad exposure to energy sector)	125.08	114.47	+9.27%
IEZ – (Companies providing equipment and services to the oil industry)	20.03	20.54	-2.49%
FENY – (Tracks performance of the MSCI USA IMI energy index)	24.71	22.59	+9.38%

Economic Developments

Valuations and Investor Sentiment:

As of February 2025, the energy sector is currently undervalued by 6.8% (found through median price/fair value ratio of constituent companies), reflecting on cautious investor sentiment. Undervalued stocks often have higher dividend yields, as well as a greater margin of safety.

As per the graph above, significant volatility was present between 2023 and 2025 (ranging from +30% to -20%), driven by fluctuating oil prices, geopolitical instability, and the global energy transition. Despite high volatility, undervaluation provides opportunity for dividend-focussed investors.

Monetary Policy:

The Fed revised its rate cut projections for 2025, bringing the target range to 3.75%-4%. This “higher for longer stance” increases borrowing costs for energy companies, placing strain on capital-intensive projects, such as renewable energy infrastructure. Consequently, this may decrease profit margins and reduce investment in the sector.

The ECB is expected to cut interest rates by 0.25% at each of its first four meetings in the first half of 2025, bringing rates down to 1.75%-2% by the end of 2025. Large-scale renewable energy projects are far more financially viable in the EU than the US, making investment into EXH1 (EU energy ETF) more appealing than XLE (US energy ETF)

Dividend Stocks to Watch

Alliance Resource Partners (ARLP): Diversified Natural Resource Company

278.49% price increase over last five years but remains at 49.3% of all time high.
Trailing P/E ratio of 9.59, lower than sector average of 10-20.
Undervalued relative to the industry based on earnings.

Dividend yield of 10.54% is significantly higher than the sector average of 4%, making it very attractive for income-focussed investors. But is it sustainable?

Operating cash flow of $785 million (TTM) covers dividends 1.96x, showing strong cash flow support. Earnings payout ratio of 46% is well below 60% threshold, suggesting the dividend payouts are sustainable.

Average analyst price target of $30.50, leaving modest upside potential of 14.79%.
Dividend Discount Model (DDM) for ARLP

The Gordon Growth Model was used to estimate the intrinsic value or ARLP based on the following assumptions: Current annual dividend = $2.80 per unit, dividend growth rate = 4.16% (weighted blend between 5- and 10-year growth rates), and cost of equity = 14.58% (derived using CAPM).

The intrinsic value was calculated as $27.99, greater than the current market value of $26.85, showing undervaluation of 4.2%. To account for potential variations in key assumptions, sensitivity analysis was conducted. Varying growth rate from 3%-5% resulted in intrinsic values from 26.8 to 29.4. Varying cost of equity between 12%-15% resulted in intrinsic values from 26.5 to 37.5.

After performing the sensitivity analysis, the observed downside potential in relation to market price is -1.3%, whereas the upside potential is 40%. It can be concluded that ARLP is valued fairly or slightly undervalued.

iShares STOXX Europe 600 Oil & Gas ETF (EXH1): Dividend-focused ETF

Yield of 4.73%, accompanied by 3.57% growth in the last year.
Top holdings are European giants Shell, TotalEnergies, and BP, limiting downside risk.
P/E ratio of 13.09 is lower than broader market ETFs (~22), potentially being undervalued.
Low expense ratio of 0.47% makes it cost-efficient for investors, especially for a sector specific ETF.

iShares Global Clean Energy UCITS ETF (INRG): Global clean energy ETF

Lower dividend yield of 1.27% reflects growth-focused holdings.
The top holdings are global leaders in clean energy: First Solar, Iberdola, and SSE.
The higher P/E ratio of 30 shows the growth potential within the clean energy sector.
INRG is down 17.64% in the last year, showing scepticism within the clean energy sector, but also offering a lower entry price.

INRG has high global diversification across the US, Europe, and Asia, reducing regional risk. Global decarbonisation trends are likely to attract far more investors towards clean energy companies.

Risks and Opportunities

Risks

Commodity Price Volatility:

the Global Economic Policy Uncertainty Index is rising significantly because of Donald Trump being elected. Uncertainty about future policies and geopolitical tensions, as we are experiencing right now, can cause large price fluctuations in the energy sector. Uncertainty creates demand-side pressures as businesses and consumers delay investments, leading to lower demand for energy.
Policy uncertainty can also disrupt energy supply chains as companies delay exploration or infrastructure investments. The EPU index has risen 66.5% since Trump won the US election.

(Source: Financial Times, Haver Analytics)

Dividend Sustainability:

Not all energy companies can sustain high dividend payouts in periods of economic downturn. Companies with high payout ratios may cut dividend payments to preserve cash. Energy Transfer LP (ET) has a payout ratio of 99.61%, meaning they distribute nearly all their earnings to shareholders in the form of dividends.
In a period of reduced demand for energy or lower energy prices, ET may struggle to maintain these high dividends. This can be seen during the 2020 oil price crash, where many midstream companies cut dividends due to cash flow pressures.

Opportunities

Attractive Valuations and Energy Transitions

Energy stocks often trade at lower valuations (P/E ratios) than other sectors, offering a margin of safety. As previously stated, the energy sector is currently undervalued by 6.8%.
Traditional large energy firms such as BP and Shell could benefit from long term growth through clean energy adoption, while ETFs which contain energy transition themes offer a hedge against fossil fuel policy risks, increasing the margin of safety.

Inflation Hedge

Energy stocks and ETFs act as a hedge against inflation, as rising energy prices accompany inflationary periods. “The US Fed warns Trump’s tariffs may fuel inflation” as import costs rise, and supply chains are disrupted. Energy stocks and ETFs are a great investment to hold during these times as they tend to significantly outperform the market.

Forecasts and Projections

Global Economic Growth

Goldman Sachs forecasts “worldwide GDP to expand 2.7% next year on an annual average basis”. Higher economic growth tends to increase energy consumption, benefitting energy companies and increasing the likelihood dividend payments are sustained.

Inflation and Interest Rates

Interest rates in the US are expected to remain above 4% in 2025, reducing the attractiveness of dividend-focused stocks in comparison to bonds. Analysts at Morgan Stanley and Goldman Sachs believe UK interest rates will be cut aggressively to 3.25%-3.5% by the end of 2025, increasing the attractiveness of dividend-focused stocks in comparison to bonds.

The US inflation rate is expected to trend around 2.4% in 2026 which is moderate and close to the target inflation of 2%, generating both positive and negative effects. UK inflation is also projected to remain within a moderate range of the 2% inflation target.

Oil Prices

Spot prices for brent crude oil are projected to continue declining through 2025 and 2026. Although declining oil prices affects energy companies differently, depending on whether they are upstream, midstream, or downstream, the main impact is likely to be negative, especially on the broader market ETFs.

Key Takeaways

The energy sector is undervalued by 6.8% which offers a safety margin.

Broad energy ETFs (XLE, VDE) are outperforming sector-specific ETFs (IEZ).
The Fed’s high rates in comparison to EU rates favours the EU for the energy transition.
Commodity volatility and geopolitical uncertainty presents risks, so companies such as Energy Transfer LP (ET) (payout ratio = 99.61%) are speculative.
The energy transition and inflation hedging potential provide great opportunity.

Sources

Morningstar (2024) 'Energy Sector Overview'. Available at: https://www.morningstar.com/sectors/energy (Accessed: 25.02.2005).

Morningstar (2025) 'Will the US Fed Raise Interest Rates in 2025?'. Available at: https://www.morningstar.co.uk/uk/news/258864/will-the-us-fed-raise-interest-rates-in-2025.aspx (Accessed: 25.02.2005).

Morningstar (2025) 'How Many Times Will the ECB Cut Interest Rates in 2025?'. Available at: https://www.morningstar.co.uk/uk/news/258864/will-the-us-fed-raise-interest-rates-in-2025.aspx (Accessed: 25.02.2005).

Yahoo Finance (2025) 'Alliance Resource Partners, L.P. (ARLP) Key Statistics'. Available at: https://finance.yahoo.com/quote/ARLP/key-statistics/ (Accessed: 26.02.2005).

TipRanks (2025) 'Alliance Resource Partners, L.P. (ARLP) Stock Forecast'. Available at: https://www.tipranks.com/stocks/arlp/forecast (Accessed: 26.02.2005).

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BBC News (2024) 'Tariffs may fuel inflation'. Available at: https://www.bbc.co.uk/news/articles/c62z3j3nydzo (Accessed: 27.02.2025).

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