The collapse in crude prices may not kill off what was once a fast-growing breed of energy company offering fat dividends, but the field of so-called "divcos" will be smaller.
Several exploration and production companies rushed to reinvent themselves as growth-plus-dividend firms when oil hovered around $100 (U.S.) a barrel, helping to fill a market demand for income following the end of income trusts. Now, many have been forced to slash their payouts or suspend them altogether to cope with dwindling cash flow and unsustainable yields. Shares in most have tumbled this year.
It raises questions about whether the model can survive a severe energy downturn.
"There was this feeling amongst the issuers and the investment bankers in Calgary before this downturn that if you didn't like your share price or your cost of capital, put a dividend in place and miraculously the market is just going to reward you for paying current income and will give you a higher valuation," said Mason Granger, fund manager at Sentry Investments.
The model requires a combination of savvy management, assets with slow rates of declining production and manageable debt, even during an energy boom. The bust of 2015 has shown how that structure is anything but a cure-all for the junior and mid-size energy segment, Mr. Granger said.
"I think it's a reminder for the sector and investors that you want to focus on the most sustainable dividend streams and that financial leverage matters," he said.
Divcos have been pressured with the rest of the energy industry as crude prices have fallen in the past year from about $90 a barrel to below $40. Cash flow has dwindled, leaving less internally generated money to pay investors. Meanwhile, share prices have tumbled, pushing up yields to unsustainable levels above 10 per cent, and in some cases, higher than 20 per cent. During the good times, yields of 4 per cent to about 8 per cent made the segment attractive, especially when weighed against fixed-income investments.
Divcos are not dead, though, just resting, said Cody Kwong, an analyst at FirstEnergy Capital Corp. Once commodity prices recover, the strongest ones, such as Crescent Point Energy Corp., Whitecap Resources Ltd. and Cardinal Energy Ltd., should recover based on their records of solid operating and high returns, Mr. Kwong says.
Heavily indebted ones, such as Lightstream Resources Ltd. and Long Run Exploration Ltd., have suspended dividends, and their shares have skidded into penny stock territory. It's led many investors to wonder if the growth-plus-yield model is even suited for an industry that rises and falls with unpredictable commodity prices.
But not all are created equal. The successful ones have a few similar attributes, including assets from which output declines at low rates with minimal spending and no need to pile on debt to finance it, Mr. Kwong said.
"When you evaluate sustainability, it's not just the cash-use-to-cash-flow ratio that everyone uses," he says. "I'll tell you what – your capital program could be zero, and your cash-use-to-cash-flow ratio could be sub-100 per cent, which is ideal. But if your production volumes are rolling back 5 or 10 per cent, that's not sustainable, because next year you're going to have a lower cash flow base."
Whitecap and Cardinal have been among a handful that have taken advantage of current industry woes by acquiring assets, and even issuing shares to help pay for them. Crescent Point has too, although this summer it chopped its dividend as crude prices tumbled below $50 a barrel for the second time this year.
In the current weak environment, investors should be asking why energy companies are paying dividends at all, said Martin Pelletier, co-founder and portfolio manager at Trivest Wealth Counsel. Cash should be either used to expand by snapping up assets now priced at bargains or preserved, depending on the company's financial health, he said.
"Maybe it's unfair to have that expectation. Maybe investors should be used to dividend cuts during periods of excess volatility in the energy space, and get the torque when [the sector] does recover and get the dividends back," Mr. Pelletier said.