For energy names, a dividend often isn’t enough

Share

It may seem as though investors are willing to chase yield every which way, but the energy sector is one of the few places where they remain hesitant to get too giddy.

Unlike REITs, which generate seemingly never-ending demand, the oil and gas companies that pay dividends are seeing a flight to quality, notes CIBC World Markets analyst Jeremy Kaliel, with the more venerable management teams and assets attracting the most attention.

While the sector has taken a hit from pesky oil differentials and a surging supply of natural gas, the likes of Trilogy Energy Corp. and Vermillion Energy Corp. have been able to churn out positive returns over the past year – 5 per cent and 8 per cent, respectively.

By contrast, Penn West Energy Corp. plummeted 46 per cent, now yielding 9.6 per cent, and Pengrowth Energy Corp. fell 44 per cent, now yielding 8.8 per cent. In any other sector, investors would consider plunging into these stocks to earn the juicy yields, but oil and gas is a tricky market.

The central issue: sustainability of dividends. While REITs can adequately forecast future rents and can predict when leases must be renewed, production problems at oil wells are hard to foresee, so cash flows are much harder to rely on. Stable cash flows are crucial because many investors like these dividend-paying names specifically for their yield, so any energy company that looks as if it could get hit with a dividend cut gets smacked in the market.

The sustainability of dividends is also a particularly prevalent issue because many of the smaller players are starting to introduce payouts. "With juniors continuing to instate dividends, we expect the suitability of underlying assets for long-term sustainability of the dividend model will come under scrutiny in 2013 like never before," Mr. Kaleil notes.

So what should investors look at to steer clear of the riskier names? Plain old production growth. The easiest way to keep paying dividends is to generate cash flow from new production. On this front, Mr. Kaliel ranks Trilogy and Vermillion as two of the safest bets – which is why investors have been willing to invest in them.

(Tim Kiladze is a Globe and Mail Reporter.)

Return to Streetwise home page.