Pay to Play: Junior oil and gas companies pay out dividends to attract attention
But are they making a mistake?
by Max Fawcett
What’s in a name? Quite a bit, as it turns out, when it comes to Renegade Petroleum. After all, the company’s decision late last year to break with the established model and transform itself from a growth-oriented junior oil and gas company that devoted most of its cash flow to drilling and exploration to one focused on paying out the bulk of it to its investors is certainly worthy of the company’s name. In a series of concurrent transactions, the company completed an all-share takeover of Canadian Phoenix Resources, raised $114.3 million in a private placement and spent $405 million to buy the assets of an unnamed Canadian producer (one that was widely rumoured to be Penn West Petroleum). What emerged was a company that had doubled its production from approximately 4,400 barrels per day to nearly 8,000, the vast majority of which is light oil. More importantly, it was now a company that was both capable of and willing to pay out a hefty dividend.
Illustration Katy Lemay
This almost certainly wasn’t an outcome that CEO Michael Erickson and his team had in mind when they were mapping out the game plan for their new company in 2009, when a freshly recapitalized Colonia Energy was rechristened as Renegade Petroleum. But while they had managed to grow their production by 84 per cent on a per-share basis by 2012, the market just wasn’t interested in what they were selling. The company’s shares were stuck trading in a range well below the $5 level it reached in early 2010, and while some of that was due to the discount Canadian crude producers have all had to deal with, it was also a reflection of the market’s impatience with the junior model.
“These companies spend three, four, five times their cash flow, and they’re expected to deliver high levels of growth,” says Martin Pelletier, the managing director and portfolio manager at Calgary’s TriVest Wealth Counsel. “If there’s any hint of that growth abating, or if they fail to meet their expectations, it makes it challenging to raise further capital.” That’s a particularly big problem when the plays they’re in are capital intensive. Well costs, which averaged around $1 million just a few years ago, now tend to come in closer to $5 million. “That’s a lot of money for a $50 million or $100 million market cap company,” Pelletier says, “so your concentration risk goes up considerably – and so does your chances of failure. Investors have shied away from that, and have put their capital elsewhere.”
Where, exactly? In yield-bearing companies, for the most part. That’s why Renegade made the switch, and why it hasn’t been alone in doing so. Whitecap Resources also decided to swap growth for yield, while Spartan Oil and Pinecrest Energy tried to do the same before the markets effectively rejected their proposed merger and drove Spartan into the waiting arms of Bonterra Energy. Rafi Tahmazian, a senior portfolio manager and partner at Canoe Financial, says they’re probably not the last companies to make that trade. “Bankers are telling them that if they want access to capital, they have to create a dividend. That opens up a significantly larger supply of money, both to invest in current shares and buy new equity should they need it,” he says. “If you’re a non-dividend payer, you have to convert to get a better cost-of-capital.”
That hunger for yield is being driven both by the lingering memories of the 2008-09 recession and the changing demographic profile of the average investor, Tahmazian says. “We believe it has a lot to do with where the baby boom bubble is. Their propensity for risk is reduced significantly, and the word ‘yield’ is still synonymous with low risk.” The problem, he says, is that while many investors associate yield with the dividends paid out by blue chip companies like telecoms and banks, the ones paid out by junior oil companies are much less predictable or secure.
And because they have to compete with established intermediates like Crescent Point Energy, Vermilion Energy and Baytex Energy – companies with long track records of paying dividends that currently yield between five and seven per cent – for the attention of investors, those juniors often have to pay out more than they’d like. “Just attaching a yield is half the battle,” Tahmazian says. “But then the other half is do you get a yield that wakes the market up enough? The smaller your company is, the more the market thinks you’re taking higher risks so it wants higher yield, which is going to mean you’re going to have to distribute more than you probably want to.”
The impact of this sector-wide shift towards paying dividends remains to be seen. Some, like Tahmazian, think it’s a catch-22 for Alberta’s oil and gas juniors: They need to pay a dividend to get the capital they need to grow, but paying out that dividend – particularly if their wells have above-average decline rates – could be the very thing that interferes with their growth. “Some of these companies are announcing that they’re going to be dividend payers and they have 35, 45, sometimes as high as 50 per cent decline rates,” Tahmazian says. “There’s so much capital required to offset those declines. We can’t see how the dividend is sustainable.”
Pelletier is less worried about the knock-on consequences for oil and gas juniors. For one, he thinks the introduction of dividends could introduce some much-needed capital discipline to the sector. “I think if they’re managed appropriately they’re less risky than some of the pure, swing-for-the-fence drillers,” he says. It could also provide companies that can’t grow with an opportunity to cash out, as the new dividend payers look for accretive acquisitions that can help them grow their inventory of drilling opportunities and support their newly-implemented yield. “If the trend continues it will be very beneficial to those juniors that want to wave the white flag, call it a day and monetize their company.”
If there’s one thing Pelletier and Tahmazian agree on, it’s that once a company decides to pay out a yield it can’t afford to reverse course. That’s why Pelletier says companies contemplating a dividend need to be certain they can pay it through good times and bad. “If you’re one of these new dividend-paying companies,” he says, “you need to plan ahead. And you’d better make damn sure that dividend is sustainable.”
Pelletier and Tahmazian aren’t the only two debating the merits of switching from growth to yield. Former Provident Energy CEO Tom Buchanan orchestrated a three-way merger between Charger Energy, the junior company that he and other former Provident executives founded in October of 2010, with Pace Oil & Gas and AvenEx Energy. The deal would create a dividend-paying company called Spyglass Resources. “We had lots of running room in that area,” he says of Charger’s assets, “but unfortunately being 3,000 barrels a day we didn’t have enough access to capital to be able to deliver on the growth that we needed to achieve as a junior oil and gas company or to see our way to growing into [a dividend-payer] on our own.” By combining the assets of Charger, Pace and AvenEx, he believes that platform can be achieved.
Not everyone agreed, though, and earlier this year Nova Bancorp Securities, a Vancouver-based hedge fund that held a small position in Pace Oil & Gas, came out against the proposed transaction. It argued that the deal undervalued Pace’s assets, and that the dividend of the combined entity it sought to create would not be sustainable. Those arguments found receptive ears, too, and eventually led to the postponement of the votes to ratify the merger until late March.