A New Energy Storm Threatens Dividends

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Are you an energy-sector investor?

Do you balance your riskier assets with a nice complement of dividend-paying stocks that provide welcome income during turbulent times?

Have you ever thought about how your portfolio would fare if those dividends were decimated?

Welcome to the next round of pain for the energy sector. Markets around the world have been struggling to stay afloat amidst Europe's debt debacle, America's economic stagnation, China's slowdown, and the like, but the energy sector has been getting the worst bruising of all. More than half of the energy listings on the Toronto Stock Exchange and the Toronto Venture Exchange are trading at less than half of their 52-week highs and a full fifth of these publicly listed energy companies are trading at less than a quarter of their 52-week peaks.

Energy Companies in the TSX and TSXV Comparison with 52 Week Highs

There are lots of explanations, and the dominant ones involve cash flows - specifically cash flows that are much skinnier than they used to be. And those skinny cash flows are about to send a bear into the china shop that is global energy.

Dividends are about to disappear.

In turbulent economic times like today, many investors protect their portfolios by ditching high-risk assets and turning instead to income stocks. Dividend-paying stocks often provide some of the best returns in slow-growth environments, so this tactic makes sense... unless those dividends evaporate.

The thing is, dividend payments are by no means assured. In much the same manner as I predicted that natural-gas reserve writedowns would hammer gas equities, I foresee a series of dividend cuts wreaking havoc on the oil and gas sector.

Why the doom and gloom? Because sometimes it doesn't take a crystal ball to predict the future of the stock market. Sometimes all it takes is some basic math.

The Numbers Don't Lie

When an energy producer sells a barrel of oil or a cubic foot of natural gas, a whole bunch of hands reach out for their piece of the cash. The government of the country where the project is located usually gets a big chunk; contractors helping to operate the project have to get paid; employees expect checks; utility and supply bills have to be paid; debts require servicing; and other development-stage projects need capital injections. These costs all come out of earnings, and it's only the money that is left over that is available to hand out to shareholders as dividends.

When oil and gas prices are strong, it is easier to ensure there's lots of money left over. When prices weaken, the dollar bills start running out. They run out even more quickly if production costs are high. And that is precisely the storm facing North America's oil and gas producers today.

For oil producers, prices in Europe are relatively strong. Tensions with Iran, civil war in Syria, the conflict between Sudan and South Sudan, and declining output from the North Sea are all supporting prices, despite the general economic malaise. In North America, none of those bullish forces are at work. Instead, infrastructure gaps have created a supply glut in the midcontinent that is pushing benchmark West Texas Intermediate (WTI) pricing to a record discount against Brent. (For an in-depth look at these discounts, check out a recent Daily Dispatch on The Tricky Calculus of Oil Price Differentials.)

And it doesn't stop there: production from the continent's booming oil districts, including the Bakken shale and the Canadian oil sands, is being hit with a second discount because of additional infrastructure deficiencies. It's a double whammy that is hitting producers hard. A barrel of Western Canada Select crude oil is currently priced 17% below WTI pricing; since WTI is discounted against Brent, that means that Canadian oil producers are getting hit with a whopping 29% discount to Brent pricing. As for an outlook, there is no reason to believe these discounts will disappear anytime soon; there is every reason to believe that oil prices in general will trade sideways for the medium term. In short, there's no light on the pricing horizon.

Gas prices are the same... only worse. As we've discussed extensively in these pages, the flood of production that poured forth from North America's shale basin pummeled gas prices to record lows. With an army of shuttered wells ready to start producing within days as soon as prices rise, there will be immense downward pressure on gas prices for the next few years.

So prices are struggling, leaving companies with fewer dollars to satisfy all those needy hands. And here's the rub: those hands are getting greedier. The cost to produce a barrel of oil or a cubic foot of gas keeps inching upward, as everything from the guar gum used in frac fluids to the taxes levied against energy production keep getting more expensive.

Engineering a complete financial model for an oil and gas producer is complicated, but the basic math at issue here is pretty straightforward. A lack of pipelines is keeping oil and gas prices in North America pinned down. The costs to pull oil and gas out of the ground are climbing, as are the expenses involved in developing new projects. With cash inflows constrained and costs rising, earnings are taking a major hit.

Most companies can absorb a quarter or two of poor earnings, as long as the future is bright. Unfortunately, the short- to medium-term future for North American oil and gas is not bright - there is no reason to believe oil pricing discounts will ease and no reason to think the glut of shale gas will abate anytime soon.

Without earnings filling their bank accounts, companies simply don't have the money to pay dividends.

Lower incomes + Rising Expenses ? Dividend Cuts Imminent

Several oil and gas companies have already slashed their dividends. I think they are the tip of the iceberg. In fact, it's more than a thought - it's a fact. Together with my analysts, I conducted a comprehensive sensitivity analysis of dividend-paying stocks in the energy sector. I stress-tested each company to see whether its promised dividends could survive an oil price drop, a gas price decline, or a continued upward creep in production costs.

For oil, I tested a price drop of 25 to 40%. For natural gas, I tested a price decline of 10 to 40%. In terms of operating costs, I assessed the impact on each company's dividend if costs climbed by just 10%.

All of these stressors are highly possible - and the results are staggering. I will be publishing them in the upcoming issue of the Casey Energy Report; it is a must-read for anyone who has or is thinking of buying any dividend-paying stocks in the sector.

Here's a teaser: of the 36 companies in my assessment, only six made it through one of my stress tests with their dividends intact. For the rest, dividends simply disappeared.

When dividends disappear, it's not just income that shareholders lose. A dividend cut can easily be the first of a long line of dominoes to fall, and most of those dominoes drag the company's share price down with them. For instance, fund managers often have no choice but to hit the sell button on a stock if a dividend cut pushes the company's dividend yield below the fund's minimum requirement. When funds start to flee, stocks are really in for a rough ride.

We are the first in the industry to conduct this kind of comprehensive stress test on dividend-paying energy stocks. The uncertainty and weakness that are plaguing global markets - and the energy sector in particular - have many investors turning to dividend-paying stocks for their reliable payouts. But many energy-sector investors who made that shift to dividends are about to get burned, because the dividends are going to disappear. Adding salt to the wound, the share prices of companies forced to slash their dividends will also get pummeled as investors, led by major yield-guided funds, abandon ship.

With this model, I have determined which energy companies will be able to keep paying their dividends, even if commodity prices tank and operational expenses soar. This information is essential for dividend-focused investors. If you want to know how to prepare your portfolio for the looming demise of energy dividends, you have to read the next issue of the Casey Energy Report.

Additional Links and Reads

Lights Out in India (The Daily Beast)

The recent Indian power outage was the biggest electricity failure in history, affecting a staggering 640 million people. As this article explains, power failures like this are not about to get less frequent. On the contrary, the outage exposed the single greatest vulnerability of the Asian economic miracle: it is fundamentally underpowered. India's electricity grid has missed every capacity-addition target since 1951; the system is now so dilapidated that 27% of the power it carries is lost to leakage and theft. The country needs to invest $1.2 trillion over the next 20 years to upgrade power infrastructure and build new capacity.

The Coming Oil Boom and Resulting Environmental Battle (The Globe and Mail)

Thanks to new technologies, we are entering an age of abundant oil. So posits a new Harvard report, whose authors predict that the world's oil production capacity could reach 100 million barrels per day by 2020, an increase of almost 20%. The tipping point will be 2015, when a glut of production will come online. The sources of oil that will fuel this boom, however, are harder to reach than the supplies of the 20th century, the technologies to extract them are more invasive, and the implications for the climate change debate are even more fraught.

$115 Oil: The Edge of Abyss (Forbes)

Oil prices hit a staggering US$115 per barrel yesterday, an amazing number given Chinese growth fears, abject German failures in the eurozone, and flatlining growth in the US. The core reason for the price surge: traders believe that Israel will go to war with Iran in October to time its "nuclear putsch" with US presidential elections. This author believes that is the wrong call. Oil at $115 is seriously overcooked given the amount of spare capacity that is sloshing around (even with Iran's 3 million daily barrels offline), though a long list of producing nations will do what they can to keep prices above $90 per barrel.

Iraq Oil Tops Three Million Barrels for First Time Since 2002 (Bloomberg Businessweek)

Crude output in Iraq climbed above 3 million barrels a day (bpd) last month for the first time since the US-led 2003 invasion that toppled Saddam Hussein, according to OPEC. The country outpaced Iran's production for the second straight month; Iranian production dropped by 173,000 barrels to 2.8 million bpd. Iraq's ability to keep increasing its oil exports will be limited by the country's infrastructure constraints and by its conflict with the semi-autonomous region in the north, known as Kurdistan.

US Freezes All Nuclear Power Plant Licensing Decisions (Environment News Service)

Federal regulators have frozen 19 final reactor licensing decisions in response to a court ruling that spent nuclear fuel stored on-site at nuclear power plants "poses a dangerous, long-term health and environmental risk." The court noted that, after decades of failure to find a permanent geologic repository, the Nuclear Regulatory Commission has "no long-term plan other than hoping for a geologic repository."

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About Marin Katusa