Lower energy prices are putting pressure on investors to be more selective in hunting for income in the oil patch.
There are still good energy companies paying substantial dividends, but sorting them from the riskier high-yield names becomes more of a priority when commodities weaken.
The generosity of some “divcos,” as they’re known, to their own shareholders is largely predicated on high oil and gas prices.
“Some management teams operate on hope. That’s their business model,” said Eric Nuttall, a portfolio manager at Sprott Asset Management.
A new breed of energy company pursing aggressive growth and promising sizable distributions has emerged in the oil patch to the delight of Canadian income investors.
With few alternatives for yield, and with money flooding back into the oil patch over the last year, divco stocks have soared.
Some companies have taken on debt and taken advantage of renewed access to equity markets to support their dividend programs. Some with less-than-top-tier assets have pursued growth through acquisitions to maintain production levels.
The sustainability of that model is tied to commodity prices.
This year, both West Texas Intermediate and benchmark natural gas futures hit their highest levels since 2011. But as the effects of winter wore off and a cool summer limited energy demand, prices have dipped back down. Since mid-June, oil has fallen by almost 10 per cent and natural gas by 15 per cent.
That’s not quite enough of a pullback to expose all of the inadequacies of the sector’s flimsier firms, said Ryan Bushell, a portfolio manager at Leon Frazer.
“If the commodity price stays favourable, they might never get found out. But there will be volatility at some point either in the market, or in the commodity, or both. That’s when the downside comes on pretty quick.”
Even some of the more reputable names, such as Whitecap Resources Inc., are maintaining cash flow through acquiring assets past their prime, with high decline rates, Mr. Bushell said. “That’s a tricky thing. All it takes is a miscalculation on one of the deals, or the commodity price to turn against them, or the market to be a little more volatile.” He said he prefers companies owning assets where future production has more upside, like Crescent Point Energy Corp.
When divcos have come under earnings pressure for whatever reason, they have proven reluctant to reduce dividends for fear of the market’s wrath.
“They’re loath to cut their dividends, so they rack up debt,” said John O’Connell, chief executive officer of Davis Rea. “The poster children of that are Long Run Exploration Ltd. and Lightstream Resources Ltd., which destroyed their balance sheets paying out dividends.”
Investors, in their zeal for dividends, may not be fully appreciating the risks and may not be properly distinguishing the safer dividend payers.
But it’s not difficult to assess the sustainability of a company’s dividend, Mr. Nuttall said.
Investors should first consider a company’s payout ratio, which expresses dividends per share as a percentage of earnings per share. Anything higher than 100 per cent is a warning sign.
Also, a company should be generating substantial cash beyond what is needed to maintain production and pay out dividends.
That figure amounts to about $110-million for Whitecap next year, by his estimates. “If you’re wondering if their dividend is sustainable or not, that’s a huge safety cushion. If the commodity price falls, it has a buffer.”
On the other hand, he would recommend steering clear of Surge Energy Inc., another company that has quickly expanded production through acquisitions.
“They’ve yet to show they’re confident drillers. It’s more been a financial entity, buying barrels. But eventually every oil and gas company has to go drill.”Report Typo/Error