Significantly lower oil prices have created concern among investors that some of the monster yields paid by Canadian energy companies may be under threat. One company that recently caught my attention due to its weaker third quarter 2014 results and monster yield in excess of 8% is Canadian Oil Sands Ltd (TSX: COS).
With oil prices at their lowest point since early 2010 and West Texas Intermediate at well under $80 per barrel Canadian Oil Sands’ dividend may be under threat.
Let me explain why.
Margins are declining
A key issue impacting Canadian Oil Sands is declining margins, not only because of softer oil prices but also due to internal cost blowouts. An important measure of the profitability for oil producers is their operating netback per barrel of crude produced. In the case of Canadian Oil Sands for the third quarter this declined significantly, down 18% compared to the equivalent quarter in 2013 to $47.16 per barrel.
Clearly softer prices are one reason for this significant decline, but another is rising costs with operating expenses for the same period up 3% year over year. This rise in operating expenses can be primarily attributed to higher natural gas prices and additional maintenance associated with outages on its sulphur processing units. It also comes on the back of increased maintenance costs during the second quarter because of the unplanned outage of one of the cokers.
These machines form an important part of the complex process which converts bitumen into light sweet synthetic crude. Due to the highly technical nature of this process coupled with the complexity of the machinery involved, it is likely these types of unplanned outages will continue to occur for the foreseeable future.
This I believe will continue to have an impact on costs and with Canadian Oil Sands’ netback falling on the back of lower crude prices there is less fat to absorb increasing costs.
Financial performance is diminishing
As a result of these declining margins, third-quarter cash flow dropped 11% year over year and net income declined a massive 65% for the same period. As a result Canadian Oil Sands’ dividend payout ratio has crept over the 100% threshold, to now be 117% of net income for the nine months to 30 September 2014. This indicates it may now be unsustainable.
But net income does not tell investors the whole story. It distorts the ratio and doesn’t represent the true amount of cash an oil company is capable of generating because it includes a number of non-cash items in its calculation. I believe a better measure is to use operating cash flow in place of net income, and when doing so the payout ratio falls to a very comfortable 56% for the year to date.
Is a dividend cut likely?
But of more concern is at the end of the third quarter, net debt had more than doubled compared to the end of 2014 to be $1.7 billion. This is because total capital expenditures including those required for the Mildred Lake train replacement project, coupled with asset retirement obligations, dividends and other liabilities exceeded cash flow from operations.
When coupled with the declining netback and falling oil prices it is clear Canadian Oil Sands needs to consider implementing measures aimed at conserving capital. This is so it can continue investing in projects which will expand production over the long-term, while leaving debt at a manageable level.
One way would be to slash the dividend and/or cut capital expenditures, though the former would earn the ire of shareholders. But a dividend cut more than likely is not necessary at this time, with the Mildred Lake train replacement and Centrifuge tailings management projects set for completion between now and the first half of 2015.
This will see a significant reduction in capital expenditures and free up funds to sustain the dividend over the short-term if oil prices remain at current lows. But if crude prices continue to slide southwards for a sustained period then it is likely Canadian Oil Sands will be forced to cut its dividend in order to conserve capital and maintain production sustaining capital expenditures.
