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Is Canadian Oil Sands Ltd. a Good Place to Go for Yield?

One year ago, oil was trading at over US$105 per barrel. Today, it’s closer to $95 per barrel, a decline of almost 10%. In addition, the International Energy Agency recently cut its global oil demand forecast by 150,000 barrels per day and spoke of a big drop in demand.

It might seem premature to worry about the sustainability of a dividend from a $10 billion company such as Canadian Oil Sands Ltd. (TSX: COS) since it has a relatively healthy balance sheet. But as an investor, one must be proactive and stay one step ahead. So what are the red flags that investors should look for that would point to potential dividend cuts?

High payout ratio

It’s important to look beyond the simple payout ratio (dividends divided by cash flow) when evaluating dividend sustainability. A better picture of dividend sustainability can be obtained by evaluating the all-in payout ratio (defined as (dividends + capital expenditures)/cash flow)). The higher the payout ratio, the less sustainable it is. With a dividend yield of 6.45%, Canadian Oil Sands’ payout ratio was 132% in the second half of 2014, and has been over 100% since 2013. So funding the dividend has and will have to come from sources other than cash flow. Given that the company has a pretty healthy balance sheet right now, I would imagine that it would fund this shortfall by issuing debt to pay for the dividend. I am concerned about this because given the macro and company-specific factors facing the company, I think that the risk that this will be more than just a short-term fix is high.

Production stalling and costs rising

For many years, Canadian Oil Sands has been plagued with rising costs, bottleneck issues, and production issues. In the first half of 2014, production declined 7% amid operating expenses increased over 10% to $52.33 per barrel, reflecting higher natural gas prices, maintenance activities, and increased drilling, and Syncrude production continued to fall short of expectations. In fact, the company lowered its 2014 Syncrude production estimate to 100 million barrels.

Commodity price outlook

All oil and gas companies are at risk in an environment of declining commodity prices. Given that there is a negative correlation between interest rates and the price of oil, and the fact that interest rates are moving higher and may continue to do so, I view the price of oil as having more downside than upside.

The companies with higher payout ratios, higher debt burdens relative to their cash flow, and with slowing production growth will suffer proportionately more. Canadian Oil Sands has two of these red flags, and the third — i.e., debt burden — may become a problem as it funds its dividend through debt in the coming years, which I believe is a likely scenario.

Management uses $95 oil and $4.50 natural gas as its assumption in its planning and estimates. According to management’s latest presentation, every $1.00 change in oil equates to $0.05 in cash per share, and every $0.50 change in the gas price (aeco) equates to a $0.03 change in cash flow per share.

Bottom line

Operational problems, slowing production growth, and a weakening commodity price outlook are all cause for concern. Add to this that the company’s all-in payout ratio exceeds its cash flow, and we have a situation that is not only unsustainable but also at risk of deteriorating further.

While high yields are very attractive, investors should watch carefully for signs that they are coming to an end. The more these signs are present, the greater the likelihood that the dividend will need to be cut and/or that the stock will underperform.

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Fool contributor Karen Thomas has no position in any stocks mentioned.

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