Are energy ‘divcos’ the new income trusts?

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The energy sector is breeding a new batch of companies that pay hefty dividends, conjuring memories of the high-flying income trust era – and raising questions about the sustainability of cash distributions.

Before the financial crisis, energy trusts that paid monthly distributions garnered major investor attention because they had tax advantages that helped them offer juicy yields. Some trusts, however, could not afford their payments and had to borrow money to make ends meet. When oil prices plummeted, those who overreached were quickly exposed.

Most of these companies ultimately survived the crisis and converted to dividend-paying corporations after the federal government banned the income trust structure. But, since then, many have struggled to catch fire. Penn West Petroleum Ltd., one of the best known "divcos," as they are called, is still trying to right the ship. The company had to cut its dividend as recently as 2013.

Lately, however, dividend-paying corporations are feeling the love. The rising energy tide lifted all boats, and years of low interest rates have helped yield-focused companies, such as Whitecap Resources Inc., Surge Energy Inc. and Long Run Exploration Ltd., attract capital and assets. All three have done large deals in 2014, and their dividend yields range from 4.75 to 8 per cent.

The acquisitions and financings are growing in size. New companies are coming to market, such as Northern Blizzard Resources Inc., which owns heavy oil assets in Western Canada. The company is looking to raise at least $500-million in an initial public offering.

With such a flurry of activity, observers are asking whether divcos are simply Income Trusts 2.0. Are investors thoroughly assessing these investments, or are they lunging at the yields without giving much thought to what could happen if crude prices fall? These fears are only exacerbated by the hot market. Because the S&P/TSX energy index is up 25 per cent in the past year, even troubled companies have posted double-digit share price gains, making it harder to distinguish between corporations with solid balance sheets and fat margins, and those that are faking it with poor assets and too much debt.

"You want to be very careful," said Les Stelmach, portfolio manager at Franklin Templeton Investments Corp. In a bull market, investors have to be wary because some companies may be adopting the dividend-paying structure "just for a lift on their stock price and a bit better cost of capital."

CIBC World Markets analyst Jeremy Kaliel concurs: "You're going to see a lot more companies in the oil patch come out with dividends, and not all of them will have a good, sustainable model."

Right now, divcos can get away with paying out more than they generate in cash flow because they promise production growth, and because crude prices remain elevated. Neither may last forever.

"If commodity prices soften and the capital goes away, then you're paying out a big chunk of your cash flow and you've got a declining asset base," said portfolio manager Martin Pelletier of TriVest Wealth Counsel, implying that some companies will struggle to come up with the money necessary to replenish their reserves. "It's a challenge."

Instead of simply looking at eye-catching yields, Mr. Kaliel suggests searching for strength in other key areas. These include: strong netbacks (the energy sector's equivalent of operating margins); low asset-decline rates; dividend payout ratios below 100 per cent; and smart capital spending that will help to grow assets organically.

For now, Mr. Kaliel isn't terribly worried about the broad divco market. Before the crisis, energy trusts masked a lot of their problems by acquiring assets to make it seem as though they had production growth; investors were happy to buy in because crude prices kept rising.

"Today, we can say probably for the first time that the space has, on a per-share basis, positive production growth without relying on acquisitions," he said.

But he and others acknowledge there have been problems with individual companies. Smaller players, such as Renegade Petroleum and Twin Butte, have recently stumbled, in some cases badly.

Plus, the market is only so big. The new companies "are all trying to occupy the same sandbox, in that they're all promising some growth and a dividend," said Mr. Stelmach. Even if they can pull it off, he added, "how many of these types of companies can the market sustain?"