When Canadian Oil Sands Ltd. (TSX: COS) cut its dividend earlier this month, I was practically salivating at the opportunity.
I knew that thousands of income investors would be lining up to punt the company from their portfolios, nervous about the company’s short-term outlook. I loved the opportunity to buy the company’s massive reserves for less than $5 per barrel. I was excited for the opportunity to load up on a company that had, at least in my view, very fixable problems.
So I waded in, and picked up shares at exactly $11 each. My timing wasn’t great, but that’s OK. I plan to hold these shares for five years or more. I can handle a little volatility.
Even though Canadian Oil Sands is a long-term hold for me, I’d still like to get paid while it recovers. With the new dividend approaching a 9% yield, let’s take a closer look to see whether it’s sustainable in a world where oil is below $60 per barrel.
Crunching the numbers
When the company announced the dividend cut in early December, it also came out with its budget and cash flow expectations for 2015. At that point, things didn’t look too bad.
Assuming production of 37.8 million barrels (which translates to 103,000 barrels per day, an increase of 6% compared to 2014), an oil price of $75, the Canadian dollar at US$0.88, and a small $4 per barrel discount between the company’s upgraded bitumen and light crude, 2015 cash flow is estimated at $1.51 per share. Add in capital expenditures of $564 million, and that leaves approximately $0.50 to be distributed to shareholders, without taking on additional debt.
That’s a pretty big problem. At $75 per barrel, Canadian Oil Sands doesn’t have enough free cash flow to meet its dividend obligations. It would have to borrow approximately $150 million to make sure investors got paid. For a company with an enterprise value of $6.3 billion, borrowing $150 million isn’t the end of the world, but that isn’t a trend any investor wants to see. Clearly, borrowing to make the dividend is viewed as a short-term option.
Worst-case scenario
At this point, $75 per barrel of oil is starting to look pretty optimistic. Let’s input $60 per barrel into the company’s 2015 budget and see where that gets us.
The company’s revenue projection of $3.07 billion gets knocked down considerably, all the way down to $2.46 billion. Assuming all other costs stay the same, cash flow from operations would total just $116 million, or about $0.25 per share. Add in capital expenditures, and the company is looking at a shortfall in the neighborhood of $450 million.
At $60 oil, the company would be forced to borrow more than $800 million annually to maintain the current dividend and pay for capex. That’s a pretty tall order, even during the good times. There’s little doubt in my mind that if oil persists at these low levels, the dividend is toast.
Does this mean you should avoid the stock? Perhaps, if income is your only goal. But from a long-term capital gains perspective, this is a great buying opportunity. The upgrader system the company has built cost billions, and gives it a huge leg up on other competitors in the region. It also has massive reserves, good enough for another 40 years of production at today’s rates. And if weakness in crude prices persist, cutting some costs won’t be difficult going forward.
From a dividend perspective though, Canadian Oil Sands needs crude to recover. Without a recovery, it just can’t maintain the payout. If you’re counting on this stock for income, I’d keep it on a very short leash.
