Exploration and Production Dividend Equities: What to Look for and What to Avoid
By: Tyler Gramatovich, Analyst for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)
Eyebrows have been raised recently about the sustainability of dividends in the energy sector as more and more companies adopt a dividend paying model, be it Master Limited Partnerships (MLPs) or traditional equities that pay dividends. Some believe exploration and production (E&P) companies may be adopting a dividend-paying structure simply to increase their stock price. While this assumption may be a bit aggressive, it is important to note that capital often becomes more accessible for dividend paying equities. Caution must be exercised in dividend investing to avoid the downward spiral of a dividend cut or even elimination.
One of the most important fundamental drivers when analyzing the sustainability of a company’s dividend is internally generated, truly distributable cash flow. Internally generated cash flow for these E&P companies is a combination of production and the “cash netback” (think of this as the cash margin per single barrel of oil after all costs are taken into account). Netbacks can be affected by many different factors and we are not just looking for the highest netback on an absolute basis. For example, companies who produce a lighter blend of oil will most likely have a higher netback as the realized price is greater than that of heavy crude, so comparing the two on an absolute basis could show a substantial difference. Netbacks are also affected by costs such as operating, transportation, royalties and interest on debt. Not only does high interest expense decrease the cash netback, it also means higher leverage, potentially introducing more volatility (risk). As we analyze potential dividend paying equities, we look for companies with low leverage, as they likely have the ability to grow by raising outside debt capital, as well as those producing more current operating cash flow via higher cash netbacks. We prefer companies who have a competitive advantage embedded somewhere in their netback, which may include, but not limited to, operational efficiencies, easy access to transportation and/or favorable hedging strategies.
So once we have analyzed and are comfortable with internally generated cash flow, how can we be comfortable with the current dividend? The main ratio we look at is called the sustainability ratio (or total payout ratio) which is calculated as (capital expenditures plus dividends)/ cash flow from operating activities. This ratio displays the company’s ability to fund the dividends from its operating cash flow, while still being able to develop its asset base via capital expenditures. We are looking for this ratio to be under 100%, which means the dividend and capital program are funded from operating cash flow, giving us a sustainable business model.
If a company has a DRIP program (dividend reinvestment program, whereby shareholders are paid out via more shares rather than cash), we also need to be aware of the percentage of shareholders making use of the program. The higher the percentage of shareholders reinvesting their dividends, the less actual cash distribution. While positive from a cash standpoint, we also need to see if the bulk of the dividend is being paid in non-cash form and if that is actually sustainable if the DRIP election were to change. Therefore when we are looking at sustainability ratios net of DRIP, for example, (capital expenditures plus dividends less DRIP)/ cash flow from operating activities, we must also run the ratio excluding the DRIP program as if the dividend was 100% cash-pay. While a DRIP program is by no means a negative sign, a company without a DRIP program shows conservative corporate governance and the fact that management is not overstretching to fund a dividend. Analyzing the simple payout ratio (dividends/ cash flow from operating activities) is also key as it shows how much flexibility the company has in its capital program.
All E&P companies face challenges and production is a constant battle. One reason we especially like certain Canadian E&P dividend paying equities is the generally respected nature of their dividends along with the flexibility of their capital program. Because Canada has a very nascent high yield market, companies often need the equity market to raise capital. As such, many of these companies pay out what we see as significant yields to attract investors and often treat their dividends in the same manner as an interest payment. In many cases, they recognize their dividend payments are extremely valuable and will do almost anything to protect them.
In terms of the flexibility of the Canadian E&P’s capital program, if a company runs into trouble with production, this will mean less cash flow (production * cash netback = cash flow), but they will easily be able to scale back their drilling program to keep the dividend intact. Clearly they cannot keep missing production guidance and scaling back capex, but the simple payout ratio gives us a feel for how far they can miss production estimates. Two other very important things we look for to mitigate this problem are low decline rates and large reserve life indexes (RLIs). A low decline rate means you can produce oil for a longer period of time without having to drill more holes. A reserve life index is the hypothetical number of years it would take to deplete a company’s reserves at current production rates. Combining both of these qualities means less drilling activity needs to take place to keep production constant.
Yield-based investors must focus on the sustainability of that yield, be it a company’s interest payments or dividends. While there are some seemingly attractive opportunities in exploration and production companies, especially Canadian-based producers, investors need to understand the company’s financial dynamics to assess that residual cash flow availability to service these payments and the ultimate dividend sustainability.