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With the collapse in prices, Canadian energy companies are bringing in less cash.

Tim Smith/The Globe and Mail

A dividend-oriented investor looking at the landscape of Canadian energy companies might feel like the most optimistic of wildcatters: Every well seems to produce an unending gusher. More than two-dozen large companies are paying dividends, with most yields topping 3 per cent. Some are creeping into the double digits.

But the reality of the oil patch is that some wells turn out to be dry holes. And investors need to eye the sector's dividend-paying equities with the same degree of skepticism.

Here are some basics to ponder: Oil and gas wells, no matter how productive, are diminishing resources. Over time, as pumping continues, less and less comes out of the ground. That means companies have to constantly drill more wells just to keep pace with past production.

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At the same time, with the collapse in North American natural gas prices and the decline in oil prices from the peak of a few years ago, Canadian energy companies are bringing in less cash. Most haven't generated sufficient cash flow to both pay their stated dividends and cover their costs of exploration and production.

Many have turned to the equity markets for money and issued more shares, a financing tactic that dilutes existing shareholdings. Rare is the company that has shown long-term growth in production per share.

"We spend a lot of time here asking ourselves what's the cost to keep production flat and the cost to replace reserves, because those two numbers are important," said Michael Zuk, an equity analyst for Stifel Nicolaus Canada Inc. in Calgary. "For example, if it costs the company $1-billion to stay flat on production, and its cash flow is $1.2-billion, that leaves very little, if any, room for real growth capital or a dividend."

Dirk Lever, the managing director of AltaCorp Capital Inc. in Calgary, who looked at 11 Canadian exploration and production (E&P) companies concluded that "according to our estimates, nobody is living within cash flow … Nobody."

While total annual dividends for the 11 firms are 30 per cent below their 2008 peak, they're still more than 40 per cent higher than in 2005, the first year of Mr. Lever's study.

The total share count for the 11 companies, however, increased 140 per cent from 2005 to 2012 from share issues and dividend reinvestment programs, or DRIPs, that pay shareholder dividends by issuing new stock in lieu of cash.

The share explosion contributed to an erosion of production per share. Only Bonterra Energy Corp., Peyto Exploration & Development Corp. and ARC Resources Ltd. had positive compound annual growth in the measure over the 2005-to-2012 period.

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All this adds up to a difficult guessing game for shareholders about whether companies' stated dividend yields will be maintained. Theoretically, companies can do it as long as the market allows them dilutive share issues. Whether management chooses to keep heading down that path is another question.

Robert Bellinski, an equity analyst for Morningstar Inc., knows the difficulty of forecasting dividend sustainability in the sector. In a late-July report called "Super Deals or Sucker Yields: Our take on dividend yields in Canadian E&P," he tabbed Bonavista Energy Corp., then trading at $17.20 with a 12-cent-per-month dividend, as "the best combination of price and yield."

Bonavista said in January it would cut the monthly payout to 7 cents. Its shares fell as low as $13.02 before rebounding to $13.55 this week.

"We made, I think, a convincing case on why they wouldn't cut their dividend," Mr. Bellinski noted in an interview. "They performed all the measures needed to shore up their capital for their drilling campaign and pay the dividend, they issued new equity, and then they still cut their dividend."

Mr. Bellinski has since warmed to Peyto. In July, he judged the company's fair value to be $30 a share, even as the stock traded around $21.50 with a yield of 3.3 per cent, relatively modest for the sector.

Peyto has since risen, trading as high as $26 in October before settling around $23 this week. But Mr. Bellinski still sees the shares as undervalued, and combined with its 3.1-per-cent yield, sees a potential annual return of 10.6 per cent over the next three years.

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"Peyto, I think, is one of the best-quality management teams in the Canadian oil patch and offers a very safe dividend and opportunity for growth – they can actually deliver on income and growth," he said.

Mr. Bellinski's top expected annual return over the next three years (16.1 per cent) belongs to Canadian Oil Sands Ltd., which he believes is still undervalued and has a yield of about 6.7 per cent. He also cites Baytex Energy Corp. (10.5-per-cent expected return), which "has delivered stellar returns, pays a reasonable dividend (5.7 per cent) and is undervalued."

Mr. Zuk of Stifel Nicolaus said he "looks at cash in the door versus cash out the door, and that tells me how sustainable the business model is." Generally, Mr. Zuk prefers models where the company covers its dividend payments and capital expenditures with its operating cash flow. That helps lead him to one of his top picks, Whitecap Resources Inc., which covered its 6-per-cent dividend, plus all its capital expenditures, using just 95 per cent of its cash flow, by Mr. Zuk's count.

He believes Whitecap will grow production per share at a modest pace and has a good mix of assets – some are prolific and declining quickly, others are more stable and predictable. "That combination gives them the right ingredients for [paying] dividends."

To help generate his list of top picks, Mr. Zuk looks at a handful of financial variables that includes production costs, the companies' balance sheets and dividend yields. Those measures rank smaller E&P Twin Butte Energy Ltd. at the top, with Whitecap in second place. Close behind them is Vermilion Energy Inc., which recently raised its dividend.

At the bottom: Pengrowth Energy Corp., Penn West Petroleum Ltd. and Bonavista Energy Corp. Mr. Zuk calls Penn West's dividend, which tops 10 per cent, "by no means sustainable."

"They're handcuffed by their investor base. They said, 'We're going to stick a fork in the ground and commit to the retail investor and keep that dividend where it is and we're going to manage our capex [capital expenditures] around that.' It's simply backwards to me. You need to first consider what it costs to keep the asset flat or grow marginally, then how much you want to pay out to your investors, not a mandatory payout."

Mr. Bellinski of Morningstar said investors evaluating the yield plays in energy should look at the institutional ownership numbers for each company. "When you see low institutional ownership, it essentially means the smart money doesn't want to touch the stock. Perhaps it's a good value, perhaps it's not, but it might just be too risky to take a chance on it."

Mr. Zuk also urges caution. "There's a lot of banner-waving about yield and perceived growth, but I think there will only be a handful of true rock stars with sustainable models. Suffice it to say, if a company is cheap, it might be cheap for a reason. You might have to pay a modest premium to get a quality name, and that's just the prudent thing to do rather than going dumpster-diving for deep value stocks that might never come back."

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