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3 Monster Dividend Yields From Canada’s Oil Patch

Some of the highest dividend-yielding Canadian stocks can be found in Canada’s oil patch. Profit growth in the patch is a result of both higher crude prices and narrowing price differentials between Canadian crude and the West Texas Intermediate benchmark price. As such, a number of operators are rewarding investors by paying hefty dividends.

But not all dividends are created equal: While a monster yield is attractive for income-hungry investors, ensuring those yields are sustainable is just as important. So now let’s take a closer look at three monster dividend yields in the patch.

Share sell-off creates a monster yield

Intermediate oil producer Twin Butte Energy (TSX: TBE) recently disappointed the market by revising its 2014 oil production guidance downward. But as a result, the yield from its monthly dividend is hitting a monster 10%. This is currently one of the highest yields in the patch, and despite Twin Butte reporting a net loss for the last two consecutive quarters, it appears sustainable as the company continues to grow its funds flow from operations.

The key measure of dividend sustainability is the dividend payout ratio, which is typically calculated by the amount of dividends paid by net income. However, this is not an accurate measure for smaller players in the patch because of the cash-intensive nature of the industry coupled with net income including a range of non-cash items. Thus, substituting funds flow from operations for net income delivers a far more accurate representation of dividend sustainability.

If we substitute funds flow from operations for net income, Twin Butte has a dividend payout ratio of a very sustainable 32%. Furthermore, the company has a policy of ensuring that total dividends paid plus capital expenditure does not exceed 100% of its funds flow from operations. When coupled with a history of successfully growing its funds flow from operations, Twin Butte’s monster yield appears sustainable.

Pengrowth’s turnaround strategy continues to unlock value

Once-troubled intermediate oil producer Pengrowth Energy  (TSX: PGF)(NYSE: PGH) continues to go from strength to strength as its turnaround strategy unlocks value. The company has strengthened its balance sheet by reducing its degree of leverage and divesting itself of poor-quality and non-core assets, and focused on boosting operational profitability.

Even after slashing its dividend by over 42% in late 2012 to conserve capital, it still has a very tasty dividend yield of almost 7%. More importantly, this dividend appears sustainable even though Pengrowth has reported a net loss for the past five consecutive quarters.

This is because the dividend payment represents only 45% of Pengrowth’s total funds flow from operations. More significantly for the sustainability of the dividend, the success of its turnaround strategy means Pengrowth’s funds flow from operations continues to grow. For the first quarter 2014, funds flow from operations had grown by a healthy 32% compared to the previous quarter. This growth should also continue as the proceeds of assets sales are used to reduce debt (and therefore interest payments), while the company focuses on boosting its profitability.

Already a key measure of profitability is Pengrowth’s operating netback per barrel of crude produced. This has grown by a healthy 43% quarter-over-quarter and by 20% year-over-year to just under $30 per barrel. This bodes well for the sustainability of Pengrowth’s dividend, making it a smart choice for risk-tolerant, income-hungry investors.

Transitioning to a dividend-plus-growth model results in success

Intermediate oil producer Long Run Exploration (TSX: LRE) pays a monthly dividend with a yield of over 7%, making it one of the highest-yielding dividend stocks in the patch. Long Run recently completed its transition to becoming a dividend plus growth company, which essentially means it is focused on rewarding investors through a regular monthly dividend while continuing to grow the value of its asset base. This saw the company declare its first monthly dividend payment of $0.0335 per share in February 2014.

Even more exciting for investors, despite the lack of a consistent dividend payment history, is that the dividend is 18% of total funds flow from operations. This is significantly lower than that of many of its peers. Long Run also shows strong growth in funds flow from operations, which for the first quarter of 2014 shot up a healthy 25% quarter-over-quarter and 44% year-over-year. Both of these things bode well for the dividend’s future sustainability.

Monster yields are continuing to appear in the oil patch as operators continue to grow profitability on higher realized oil prices and narrowing price differentials. But investors should be aware that smaller oil companies continue to experience particularly volatile share prices.

The market is highly sensitive to those who either fail to deliver as promised or find themselves over-leveraged and underperforming. This is a key reason why so many companies operating in the patch start out with moderate dividend yields but then see their share price tumble after disappointing the market, leaving them with monster yields.

These monster dividend yields are also an indicator of the degree of risk investors undertake when investing in smaller oil explorers and producers — keep this in mind if you choose to invest in this lucrative sector.

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Fool contributor Matt Smith does not own shares of any companies mentioned.

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