When it comes to income shares, the UK stock market has plenty of high dividend yields for investors to take advantage of. And right now, one of the highest belongs to Serica Energy (LSE:SQZ) at 15%.
Of course, dividends aren’t guaranteed and, on occasion, can be cut if there aren’t enough cash flows to support them. This becomes increasingly more common as yields get higher, so seeing a double-digit yield from Serica certainly raises some alarm bells.
But there are always some exceptional businesses that manage to beat expectations and keep the money flowing. So is Serica one of these exceptions?
Why’s the yield so high?
There are two ways for a dividend yield to increase. Either the company raises shareholder payouts, or the share price takes a tumble. In the case of Serica, the latter appears to be the root cause. For reference, since 2022, its shares have been stuck on a downward trajectory, falling by over 70%!
There are a variety of factors at play here, including regulatory, operational, and macroeconomic challenges during the period. In 2022, the UK government introduced a windfall energy tax that boosted the effective tax rate to as high as 78%. Serica’s production between 2022 and 2024 fell from 40,000 to 34,600 barrels of oil & equivalents per day. And at the same time, natural gas prices have fallen steeply over the last three years.
It’s a perfect storm of headwinds that’s translated into falling revenues and earnings. And in 2024, the group’s payout ratio dipped below 100%. In other words, the company’s now paying out more in dividends than it’s generating in earnings.
Reasons for optimism
The Energy Profits Levy isn’t scheduled to end until 2030. But Serica’s production levels appear to be getting back on track. The damage caused by Storm Eowyn at the start of the year has caused management to cut production guidance for 2025. But assuming the weather doesn’t take a turn for the worse in 2026, production volumes are on track to rise considerably.
A combination of new wells and efficiency boosts could push Serica’s production to 42,986 barrels in 2026, according to a recent report by investment firm Auctus Advisors. A big driver of this is the Belinda project, scheduled to start production in the first quarter of 2026. And later in 2027, the firm’s Buchan project is expected to kick off. The latter is crucial given it’s expected to reach a peak production of 35,000 barrels by itself.
At the same time, natural gas prices have been steadily rising again since August 2024. And while they’re still nowhere near the peaks of 2022, this upward trend still helps bolster Serica’s profit margins.
The bottom line
Providing no more spanners are thrown into the works, Serica’s dividend sustainability should improve over the next 12 months. As such, the current 15% yield appears tempting. However, this comes at the cost of considerable risk.
Management has no control over the weather or natural gas prices, both of which could create a new round of delays and earnings drops. Personally, the risk is too high for my tastes. Nevertheless, Serica still presents a potentially interesting opportunity if it can steer the ship back on course. That’s why investors may want to consider adding it to their watchlists.
