One year ago, oil was trading at over US$105 per barrel. Today, the price of oil is below $70 per barrel, for a decline of over 30%. The International Energy Agency (IEA) recently cut its global oil demand forecast again, this time by 250,000 barrels per day, and spoke of a big drop in demand.
While it once would have seemed unreasonable to worry about the sustainability of a dividend from a $10 billion oil sands company benefitting from oil at over $100 per barrel and with a relatively healthy balance sheet, this does not seem so unreasonable anymore.
Canadian Oil Sands Ltd. (TSX: COS) has been underperforming for far too long, but has been able to maintain a healthy dividend due to the strength in oil prices. Now that oil prices are in a freefall, the company’s dividend looks precarious. Here is what investors should be worried about.
1. High payout ratio
It is important to look beyond the simple payout ratio (dividends dividend by cash flow) when evaluating dividend sustainability. A better picture of dividend sustainability can be obtained by evaluating the all-in payout ratio (defined as (dividends + capital expenditures)/cash flow)). The higher the payout ratio, the less sustainable it is. With a dividend yield of 10.1%, Canadian Oil Sands’ payout ratio was 130% in the third quarter of 2014, and has been over 100% since 2013. So funding the dividend has and will have to come from sources other than cash flow.
2. Production stalling and costs rising
For many years, Canadian Oil Sands has been plagued with rising costs, bottleneck issues, and production issues. In the third quarter of 2014, production declined again and total operating expenses increased 3.4% to $47.73 per barrel, reflecting higher natural gas prices, maintenance activities, and increased drilling, and Syncrude production continued to fall short of expectations. In fact, the company lowered its 2014 Syncrude production estimate again to 95 to 100 million barrels.
3. Balance sheet risk
The company’s stated debt target range is $1 billion to $2 billion. With current debt levels of $1.89 billion (up from $1.6 billion at December 31, 2013), this does not leave the company with much room to increase debt. Last quarter, the company helped finance the dividend and capital expenditures through the issuance of $200 million of debt.
4. Commodity price freefall
All oil and gas companies are at risk in a declining commodity price environment.
The companies with higher payout ratios, higher debt burdens relative to their cash flow, and slowing production growth will suffer proportionately more. Canadian Oil Sands has all of these red flags.
Management’s 2014 cash flow per share guidance was $2.62 as of October 30, 2014. This guidance is based on $85 oil. Oil has been trading below $70 and it seems clear that oil will average somewhere below the $85 that Canadian Oil Sands has incorporated in its forecast and numbers. According to management’s latest presentation, every $1.00 change in oil equates to $0.05 in cash per share, and every $0.50 change in the gas price (aeco) equates to a $0.03 change in cash flow per share.
Although Syncrude is a world-class mine with a proved plus probable reserve life of 23 years, and the company has made big investments to improve its reliability and output, which should slowly begin to impact the numbers in the next year or so, the company is still clearly in for hard times ahead.
What’s next for Canadian Oil Sands?
Operational problems, slowing production growth, and a weakening commodity price outlook are all cause for concern. Add to this that the company’s all-in payout ratio already exceeds its cash flow, and we have a situation that is not only unsustainable, but also at risk of deteriorating further.
A situation where a company has a payout ratio that exceeds its cash flow is not sustainable. The high yields are very attractive while they last but investors should watch carefully for signs that it is coming to an end. The more of these signs that are present, the greater the likelihood that the dividend will need to be cut and/or that the stock will underperform.
