Ithaca Energy (LSE:ITH) is the sort of stock that attracts the attention of investors looking to generate passive income. That’s because the oil and gas producer paid a dividend of $0.40 a share (31.3p at current exchange rates) in respect of its year ended 31 December 2023 (FY23).

If this is repeated during FY24, it means the stock is presently yielding an amazing 24.7%.

The dividend cost the company approximately $400m. However, it recently announced a deal in which it will acquire the upstream assets of Eni UK. If concluded, the company hopes to return at least $500m to shareholders in 2024.

Crunching the numbers

But for the purposes of my example, I’m going to assume that the dividend of $0.40 is retained for a period of 20 years.

On the basis that the share price doesn’t change — and that all dividends are reinvested buying more of the company’s stock — my hypothetical £20,000 would turn into £1.65m within two decades.

At that point, a 24.7% annual return would give me an income of £40,829 — equivalent to £3,402 a month.

Wow!

The million dollar question

Therefore, to answer the question posed in the headline to this article, yes, Ithaca Energy could turn £20,000 of savings into passive income of more than £3,000 a year. But this conclusion comes with a series of warnings.

Firstly, dividends are never guaranteed. The company only listed in November 2022. It therefore doesn’t have a long track record of offering generous payouts, on which some reliance could be placed.

A stock offering a double-digit yield could be a value trap–something that appears to be a bit of a bargain but, in reality, is the opposite. Rarely is such an impressive yield sustainable.

Also, I think it would be unwise to put all of my hypothetical £20,000 into one stock. Diversification is a way in which risk can be spread across several shares. Having one investment means success (or failure) is dependent upon a single company. Things could go horribly wrong.

That’s particularly true for Ithaca Energy, which operates in a highly volatile industry where earnings are almost entirely dependent upon oil and gas prices.

To try and provide some certainty over its revenue the company enters into hedging arrangements with customers. At 31 March 2024, the selling price for just over a third of its annual production had been agreed in advance.

But for a company to maintain a healthy dividend it needs to remain profitable and cash generative. And this is where Ithaca Energy faces a unique challenge. Because it generates the majority of its income from the North Sea, its profits are subject to a penal rate of tax of 75%. This probably explains why its share price has fallen 45% since making its stock market debut.

Final thoughts

Because I believe there are other, less risky sectors in which to invest, I don’t want to buy the company’s shares.

However, there are alternative ways of generating generous levels of passive income from high-yielding shares.

For example, there are plenty of FTSE 100 stocks presently offering returns of 6%-8%. Over 20 years, achieving the top of this range would see £20,000 turn into monthly income of £621.

I’m therefore going to continue looking for other dividend shares to include in my portfolio.