Is this passive income idea too good to be true?

Some passive income ideas can seem too good to be true.

Take investing in dividend shares, for example. Many provide a substantial stream of unearned income. But some of them can involve heightened risk, which might mean that the income falls or dries up in future.

Double-digit yield

This has been on my mind lately when I have been thinking about Diversified Energy (LSE: DEC). The company currently offers a dividend yield of 10.2%. So, if I put £10,000 into Diversified shares today, I would expect annual passive income of around £1,020. Not only that, but Diversified pays quarterly and has increased its annual dividend in recent years.

That all sounds very attractive to me from a passive income perspective. But how can the little-known energy company support a double-digit yield?

New business model

Diversified is in the natural gas and oil business. But whereas other energy companies get in early in the lifestage of a gas well, Diversified gets in late. It specialises in buying up old wells other operators may see as no longer worth owning.

This is an unconventional business model in oil and gas. It could be a stroke of genius. It takes away the vast exploration and development costs associated with energy majors like BP and Shell. But it raises the question of how costly wells are to maintain as they enter their twilight years. Ultimately, wells need to be plugged and that costs money. With around 67,000 wells on its books, the liabilities could be substantial for Diversified. If capping costs eat into profits, that could hamper its ability to pay out those juicy dividends.

Positive outlook

Diversified is well aware of the capping issue. Indeed, it announced this week that it has acquired a company that specialises in capping wells.

There was other good news in this week’s announcement. The company has expanded its footprint, acquiring new wells that let it grow in the US outside its heartland in the Appalachian mountains. Production last year was up 19%. The unconventional business model seems to have been lucrative so far, and is growing at speed.

Is this passive income idea for me?

How lucrative the model remains in future depends partly on energy prices, which are outside the company’s control. In the short term it manages this risk through hedging its output, or agreeing sales in advance at a set price. But in the long term, any sustained downturn in energy prices could hurt profits at the firm and its ability to fund the dividend.

I also think the capping costs for its estate are a significant risk. If they turn out to be substantial, that could hurt the company’s dividend. That means that the dividend is not guaranteed to last. But that is true of any dividend. For now, at least, the dividend is not too good to be true. It reflects the success seen so far at Diversified. That may continue.

But I think the high yield reflects the risks of the novel business model pioneered by Diversified. In time, that could mean the dividend is not sustainable. So, although the dividend is not too good to be true today, that does not mean that it will continue. I am not buying Diversified for my portfolio at the moment.

Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.