Canadian junior energy producers look like income trusts | Investing | Financial Post
November 27, 2012
Canadian junior oil and gas companies seem to be reinventing their business plans in order to once again gain access to capital after three producers last week announced they will switch to an income-and-growth model not unlike the former income trusts that dominate the larger-sized intermediate exploration and production companies.
Pinecrest Energy Inc. and Spartan Oil Corp. announced their intent to merge and institute a dividend of approximately 8%, while Whitecap Resources Inc. announced plans to implement a monthly dividend early next year that will yield about 7%. The announcements come after two others — Twin Butte Energy Ltd. in 2011 and Renegade Petroleum Ltd. earlier this year — also converted into yield-and-growth companies.
Historically, junior oil and gas companies received capital from investors looking for high growth rates. It was not unusual to see such companies spend two to three times their annual cash flow trying to achieve growth rates in excess of 20% to 25% per year.
Investors since the 2008 recession, however, have turned away from high-growth companies, focusing instead on perceived lower-risk dividend-paying companies. But very few of the intermediates have delivered on the growth side of the equation and many have also been equally challenged to sustain their dividend.
Thanks to higher-cost resource plays, capital budgets have more than doubled since 2006 when measured as a percentage of cash flow, said a recent TD Securities report.
In other words, capital budgets have expanded while cash flow has remained somewhat flat for oil producers and down for gas producers.
Therefore, we believe it is very important investors understand the risks and ask how and if these junior companies can do a better job of managing growth and sustaining yields than their larger peers.
A great starting point is to look at a company’s payout ratio, which represents its ability to pay a dividend over the longer term. This is done by taking the planned dividend payment and capital expenditures and dividing by estimated cash flow.
Anything more than 100% means the company will be using debt to pay its dividend to investors. Interestingly, the intermediates on average have had payout ratios above 100% since the federal government’s decision to tax income trusts back in 2006.
We also recommend looking at a company’s balance sheet strength, capital efficiencies, production decline rates, netbacks and hedging activity.
The greater the decline rate and the weaker the capital efficiency, the more money required to maintain production rates, cash flow and, subsequently, the dividend. In addition, the stronger the netback (lower cost structure and higher priced commodities), the easier it is to generate free cash flow and sustain the dividend.
A strong balance sheet also affords a company time to meet its objectives without having to immediately cut its dividend. Finally, commodity hedging is important to minimize the risk of diminished cash flow from a correction in oil and/or natural gas prices.
In conclusion, we think this could end up being a win-win scenario for the sector, because junior producers may now have the option of either growing into dividend companies and raising capital as part of that plan, or selling out to an existing dividend-paying junior producer.
That said, the jury is still out on whether the income model will work for smaller producers. To that end, investors should at least undertake some diligence and not base their decisions to invest solely on the attractive yields being offered.
Pinecrest Energy Inc. and Spartan Oil Corp. announced their intent to merge and institute a dividend of approximately 8%, while Whitecap Resources Inc. announced plans to implement a monthly dividend early next year that will yield about 7%. The announcements come after two others — Twin Butte Energy Ltd. in 2011 and Renegade Petroleum Ltd. earlier this year — also converted into yield-and-growth companies.
Historically, junior oil and gas companies received capital from investors looking for high growth rates. It was not unusual to see such companies spend two to three times their annual cash flow trying to achieve growth rates in excess of 20% to 25% per year.
Investors since the 2008 recession, however, have turned away from high-growth companies, focusing instead on perceived lower-risk dividend-paying companies. But very few of the intermediates have delivered on the growth side of the equation and many have also been equally challenged to sustain their dividend.
Thanks to higher-cost resource plays, capital budgets have more than doubled since 2006 when measured as a percentage of cash flow, said a recent TD Securities report.
In other words, capital budgets have expanded while cash flow has remained somewhat flat for oil producers and down for gas producers.
While investors may be partially forgiving on missed production-per-share growth targets, they are not as kind when it comes to dividend cuts. For example, the share prices of both Enerplus Corp. and Pengrowth Energy Corp. more than halved this year after large dividend cuts.
Therefore, we believe it is very important investors understand the risks and ask how and if these junior companies can do a better job of managing growth and sustaining yields than their larger peers.
A great starting point is to look at a company’s payout ratio, which represents its ability to pay a dividend over the longer term. This is done by taking the planned dividend payment and capital expenditures and dividing by estimated cash flow.
Anything more than 100% means the company will be using debt to pay its dividend to investors. Interestingly, the intermediates on average have had payout ratios above 100% since the federal government’s decision to tax income trusts back in 2006.
We also recommend looking at a company’s balance sheet strength, capital efficiencies, production decline rates, netbacks and hedging activity.
The greater the decline rate and the weaker the capital efficiency, the more money required to maintain production rates, cash flow and, subsequently, the dividend. In addition, the stronger the netback (lower cost structure and higher priced commodities), the easier it is to generate free cash flow and sustain the dividend.
A strong balance sheet also affords a company time to meet its objectives without having to immediately cut its dividend. Finally, commodity hedging is important to minimize the risk of diminished cash flow from a correction in oil and/or natural gas prices.
In conclusion, we think this could end up being a win-win scenario for the sector, because junior producers may now have the option of either growing into dividend companies and raising capital as part of that plan, or selling out to an existing dividend-paying junior producer.
That said, the jury is still out on whether the income model will work for smaller producers. To that end, investors should at least undertake some diligence and not base their decisions to invest solely on the attractive yields being offered.
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