Dividends Fail to Attract Small Cap Buyers: Corporate Canada

The shift by Canada’s small energy producers to pay dividends for the first time is failing to win over investors as rising costs and reduced prices for Canadian crude have made energy the second-worst performing industry group in the country this year.

Three of the four oil and natural gas producers with market valuations of up to C$1 billion ($1 billion) that announced dividends this year have declined since the move. The producers include Equal Energy Ltd., Renegade Petroleum Ltd. and Whitecap Resources Inc.

Higher costs for drilling wells, and a near record $40 gap between Canadian crude and global benchmarks have overshadowed the junior producers’ bids to attract investors by paying dividends. The payouts may be harder to sustain for smaller companies with fewer projects and less cash flow than bigger rivals such as Suncor Energy Inc.

“With a number of the new names, particularly these smaller companies, we’re a little bit cautious,” Les Stelmach, who helps manage about C$15.8 billion at Bissett Investment Management in Calgary, said in a phone interview.

Executives new to paying dividends must refocus on delivering income with less growth, shifting from a strategy of increasing production and cash flow, he said. “It’s not like flipping a switch.”

Four other small producers may soon offer dividends, according to an analysis by National Bank Financial, as they try to lure investors that currently reward income over growth.

Dividends Popular

Dividends are popular in Canada’s oil patch, with 73 percent of companies on the S&P/TSX Energy Index making payments, versus 65 percent on the broader index. The energy index has fallen 5.2 percent this year, the second-worst performing among industry groups on the broader index, beating only the materials industry.

The trend of paying out a portion of cash flow to boost valuations has now gone “down market,” to smaller energy companies, said Tim Murray, an analyst at Desjardins Securities Inc. in Calgary. “Usually dividends sit with your larger companies, guys that generate lots of cash flow.”

Canada’s smallest energy companies, known as the juniors, loosely defined as those that produce less than 10,000 barrels of oil a day, historically drilled to prove reserves and increase production to be acquired. With fewer ready buyers and muted economic growth prospects depressing energy stocks, some are instead trying to entice investors with monthly payments.

Energy stocks in Canada have fallen this year because of constrained pipeline capacity that has widened the gap between Canadian crude and global benchmarks.

Drilling Costs

In addition, drilling has become more expensive, forcing companies to invest more money into operations and take more time before they become profitable. Much of the recent increase in fossil fuel production has resulted from the use of horizontal drilling and hydraulic fracturing technology, which is more costly than traditional vertical drilling.

Equal Energy, which forecast production next year of the equivalent of 7,900 barrels of oil a day, will begin issuing a 20-cent dividend on Jan. 1 after the sale of royalties and land to Keystone Royalty Corp. for C$11.4 million.

The dividend is to “reward shareholders for their patience,” Equal Energy Chief Executive Officer Don Klapko said in a phone interview from Calgary. “We think it’s something the overall market is looking for.”

Twin Butte

Twin Butte Energy Ltd., producing 13,750 barrels a day in the third quarter, led the charge among smaller producers when it acquired Emerge Oil & Gas Inc. on Jan. 9 and began paying a dividend the next month. That was followed on Oct. 29 by Renegade Petroleum, the smallest of the group, with 3,923 barrels a day. Whitecap Resources, with output of 15,800 barrels a day, promised a dividend on Nov. 20, followed a week later by Equal Energy.

The stock lift has only materialized for Twin Butte, up 11 percent including dividends since it announced the payout, versus peers on the S&P/TSX Energy Index, with a drop of 5 percent including the dividends. Equal has fallen 15 percent since announcing its dividend. Renegade fell 5.7 percent since its move, while Whitecap is down 3.7 percent.

“Others haven’t received that positive market reaction,” said Mason Granger, who manages C$500 million at Sentry Investments Inc. in Toronto, including Renegade shares.

“They have to deliver for a number of quarters in a row under the discipline of that dividend model and exceed expectations before the market’s going to reward them with that higher multiple,” Granger said.

Share Response

“We’re somewhat disappointed with the response of the share price,” Klapko said, blaming the stock’s decline on “unrealistic” investors calling for a higher dividend. “We think some of our shareholders had some unreasonable and frankly unsustainable expectations.”

Twin Butte CEO Jim Saunders didn’t return a phone message seeking comment, nor did Whitecap Resources CEO Grant Fagerheim and Renegade Petroleum Chief Financial Officer Alex Wylie.

Additional companies that could become income names in the energy sector include Crew Energy Inc., Legacy Oil + Gas Inc., Pace Oil & Gas Ltd. and Surge Energy Inc., Calgary-based National Bank Financial analysts Matt Taylor, Dan Payne and Ryan Mooney said in a Nov. 20 note.

Issuing a dividend is “something we evaluate and we’re looking at,” said Trent Yanko, CEO of Legacy Oil + Gas. “Our asset base is amenable to that type of structure, but it’s also amenable for continued growth.”

Crew Energy CEO Dale Shwed didn’t return a phone message seeking comment, nor did Pace Oil & Gas CEO Fred Woods and Surge Energy CEO Dan O’Neil.

Hybrid Model

Smaller energy companies may not be able to afford to explore and pay dividends in some of Western Canada’s early-stage areas of light oil production, where it costs more to maintain output as the flow of oil drops faster than in mature fields, said David Neuhauser, who manages $100 million at Livermore Partners Inc. in Northbrook, Illinois. Analysts have dubbed the strategy a “yield plus growth” model.

“They’re trying to be hybrids,” promising production growth and income, Neuhauser said. “You’re going to keep spending money and the question is, where’s that money going to come from if you’re going to distribute a pretty high chunk of fund flows to shareholders every month.”

Analysts including Murray are watching that dividends can be maintained, usually measured as a so-called sustainability ratio by adding capital spending and dividends then subtracting those reinvested, and dividing by cash flow.

“If it’s over 100 percent, it’s not sustainable,” Murray said. “If you cut your dividend, your stock goes with it.”