It happened before, back in 2008 and 2009 many oil and gas producers cut their dividends as the price of oil collapsed. Today, there is no need for oil prices to fall dramatically for that to see a repeat. Now that natural gas prices have already been decimated, all it takes is an extended period of lower oil pricing before capital expenditures/dividend cuts hit the most vulnerable producers across the board. I picked Enerplus Resources as our textbook example as it has a balanced commodity weighting (50% oil/50% gas) trading with a 15% dividend yield signalling a dividend cut may be in the cards.
Enerplus Corp. ERF.TO 25.895 [-0.105] currently pays $2.16/share on an annual basis and is guiding for 83,000 boe/d in average production for the year. For our scenario let’s use the following commodity strip pricing:
- 2012 average production 83,000 boepd (50% liquids)
- 2012 capex program $800M
- Edmonton Par Realized oil price of $75/barrel
- Natural gas liquids Realized price of $50/barrel
- Natural gas price at $2.10 /mcf
In Q1-12, ERF realized $85CAD per barrel of oil in a $100 WTI environment. Now that WTI is under $85, using $75/barrel is fair as it accounts for the company’s hedges of 62% of its oil volumes at $96/barrel WTI. ERF’s natural gas hedges are insignificant (27% of production at $2.17/mcf) so using a $2.10/mcf price is realistic and slightly above the YTD average price for AECO ($2.00/mcf). As for NGLs, prices have been under pressure in both the US and Canada, $50/bbl is fair with NGL volumes barely accounting for about 5% of production.
The sustainability ratio is a disaster coming in at 200% which means the company is spending twice its income this year ($600M shortfall!). If the $800M program is executed, the net debt will rise from $850 million at the end of 2011 to $1.5 Billion at the end of 2012. This translates into a debt to cash flow multiple of 2.5 up from 1.6 in Q1-12. Something has got to give and it will either be a cut to the capex or a cut to the dividend unless the company monetizes some of its assets. In that regards, ERF is looking to sell $250-$500M in assets. But that is not the solution and would not render the dividend sustainable. If the dividend is not cut, the capex would have to take the hit which impacts the production growth rate. The $800M only grows production 10% so how much can you cut without neutralizing growth?
Can the company raise more money? The company already did with a $330M in an equity offering back in February at $23.45 per share. Obviously, at the current price, this would not be desirable. So we turn towards the company’s bank lines to see if they can avoid tapping the market for money. ERF recently turned $405M into unsecured notes (long term debt) which allows it to enjoy more financial flexibility as its $1 billion bank line is lightly tapped and can absorb the $600 million shortfall. However, funding the dividend and the capital program through debt is not the smartest thing to do as it undermines the long term health of its balance sheet.
The credit line can only absorb a shortfall for this year which means the company absolutely needs to sell some non-core assets, preferably $500M of those. Failing to do so, downward pressure on the dividend and/or capital spending (impacting growth rate) will only rise. A 50% cut to the dividend brings the total payout ratio down to 167% saving the company $200 million (shortfall cut by 33%) and brings the yield closer to peers. The pressure will only be increasing if oil prices drop below $80 WTI as Canadian oil prices suffer even more due to differentials.
Finally, we take a look at the DRIP where investors recycle their dividend into more shares. Since it has just been approved in the company’s annual meeting, the impact would not be significant enough as ERF is forecasting DRIP will contribute $70M this year.
Enerplus is a perfect example for assessing the risks of lower oil prices to dividend paying oil and gas stocks by running through the sustainability ratio (living within cash flow) and financial flexibility (debt leverage, bank lines, dispositions and DRIP). The industry has been facing months of depressed natural gas prices, what happens if the drop in oil prices turns out to be a similar scenario? This is where you take out that calculator and review your dividend paying energy producers to find out what the answer is. For ERF, it’s clear that the dividend or the capex or a combination of both would have to take a cut or risk jeopardizing their financial health in the long run.
Do you think ERF will cut its dividend?