The last few months have seen a flurry of E&Ps announcing changes to their business strategy, moving from a growth-through-drilling focus toward an income-and-dividend model.
These companies realize things are changing in the oil patch. Commodity price forecasts are down and investor euphoria over billion-barrel resource plays is fading.
The stocks of junior producers went from 9.3x debt adjusted cash flow in 2011 to 1.8x in the coverage universe of Canadian brokerage firm Canaccord Genuity (dated Jan. 2/13).
It leaves these companies with some tough choices about how to improve their trading multiples, to get back a bit of their glory days of 2009-2011.
With the winds behind the resource-play boom waning, companies are looking for ways to protect these valuations. It appears that increased payouts to shareholders are the weapon of choice.
But the market remains cautious about this new strategy, with none of these new junior dividend stocks seeing much share price appreciation, until Whitecap Resources (WCP-TSX; SPGYF-PINK) jumped last week—six weeks after they announced their strategy.
Here’s a few data points:
On November 20, Calgary-based intermediate oil player Whitecap Resources (WCP-TSX) announced a change in corporate strategy, moving to focus on “paying sustainable dividends.”
On November 21, Pinecrest Energy (PRY-TSX) and Spartan Oil (STO-TSX) announced they were merging and transforming into a dividend-paying corporation. But investors didn’t like that deal, sending both stocks down after the news. After the deal was scuttled, both stocks rose.
On December 20, Pace Oil and Gas Ltd (PCE-TSX), AvenEx Energy Corp. (AVF-TSX) and Charger Energy Corp (CHX-TSXv) said they were merging to form a dividend-focused company.
Whitecap plans to pay $0.05 per month to investors, beginning in January 2013, yielding about 6.4% at today’s share price. Before January 2—six weeks after it said it was about income now, the stock was stagnant.
Of course, sending more money home to investors means putting less cash to work in the field. Whitecap’s stated forecast is to pay out about 32% of its cash flow on dividends, leaving an anticipated 63% cash for capital projects: drilling, completions and facilities.
Such a move to cut drilling would likely have sent investors running for the hills, even a few short months ago. As recently as April 2012, newspapers like Canada’s Financial Post were praising Whitecap for its growth potential. Investors wanted to see Exploreco money put to work—dividends were for little old ladies.
That’s because the last several years the climate in the industry and broader economy favored a strategy of growing through aggressive drilling.
That was primarily due because of commodity prices. The last decade has been salad days for the petroleum sector. Oil prices rose to previously unthinkable levels. Equity markets soared. Investors cheered.
The energy sector offered those investors something they’d been desperately seeking: upside. Inflation was threatening to digest real returns on traditional equities, and to boot, many investors—especially the retail buyers becoming more prominent in the energy space—were carrying big debts and staring down poorly planned and under-funded financial futures.
The possibility of supercharged double- or even triple-digit returns in the E&P game was just the answer. After all, even “sluggish” giants like ExxonMobil (XOM-NYSE) were up over 200% during the bull run.
This provided the kindling for The Growth Story. In-ground oil reserves were soaring in value, and the trend was your friend as energy-hungry upstarts like China and India were threatening to buy every last barrel of crude they could sail a tanker to, sending prices higher.
In such an environment, the more barrels a company booked, the better positioned it was to benefit from exploding oil prices. E&Ps drilled aggressively—the Baker Hughes oil rig count more than doubling between 2005 and 2008, the first substantial increase since the 1980s. If you weren’t drilling, you were dying.
But during the last year, the outlook for oil has become more tempered. Largely because the drilling rush was so successful—creating a surge of new North American oil production.
In the year since September 2011, U.S. crude output jumped 16%, or 900,000 barrels per day. This is the biggest rise in nearly 30 years, leading analysts to speculate that this new supply will dampen prices. US prices are now $15/barrel below world prices and Canadian light oil prices are a further $10/barrel cheaper.
The other headwind for E&Ps is recent data showing that a number of much-hyped resource plays are not living up to (admittedly high) expectations. Many wells that came on at mouth-wateringly high rates are now dropping off hard and fast.
TD Newcrest analyst Roger Serin pointed to exactly this issue in a recent cautionary note on resource player PetroBakken Energy (PBN-TSX), stating that “issues relating to high decline rates, a rising cost structure and a balance sheet that in our analysis provides limited future flexibility past 2011, causes us to take a more cautious approach.”
Analysts are realizing that lower-than-expected production from resource plays means a bite out of profits. That’s a big part of the reason the consensus forecast of long-term earnings growth for the S&P 500 Energy index has been falling steadily throughout 2012, now sitting at its lowest level since 1995 (save for the brief inflection seen during the 2008 financial crisis).
With all of these clouds looming over the E&P sector, will companies like Whitecap be able to shore up their valuations by giving money back to shareholders through dividends?
At current share prices, the strategy looks dubious. Whitecap Resources’ planned yield of 7% is only slightly higher than the current 4.6% average yield on larger, perceived-safer multinational oil companies.
All of the new yield stocks say they’ll spend 100% of cash flow on drilling and dividends. That’s where investors are getting cautious on valuation. How do you mix high-risk junior production with a blue chip business model?
If capital cost overruns or unbudgeted expenses rear their heads, these companies will either have to cut dividends or reduce upkeep of their fields. Both of which mean a fall in yield—either today, or down the road as production falters.
Such disappointments will almost certainly mean a cut to share prices. After which, dividends and valuations may well re-calibrate at attractive yields.
The current, more-cautious investment environment might see investors more receptive to dividend cheques rather than capital gains through share price growth. But can E&Ps with waning cash flows pay enough to make themselves relevant as income investments?
Until the new dividend model is put through the wringer of field reality, investors should be cautious of gilded promises.
– By contributing editor David Forest
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