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Should You Take a Bite Out of This 10% Yield?

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Dividend yields add to total returns. High yields are mesmerizing, but most of the time when yields get to that level, investors start wondering if the dividends are sustainable.

Vermilion Energy (TSX:VET)(NYSE:VET) currently offers a yield of 10.2%. Can you trust the oil and gas producer to maintain its dividend?

Is Vermilion Energy’s +10% yield sustainable?

On Vermilion Energy’s (TSX:VET)(NYSE:VET) website, it says it pays a reliable and growing dividend. The company has been keeping its word; since 2003, it has maintained or increased its cash distribution or dividend.

Vermilion pays dividends from its cash flow, which is affected by changing commodity prices. At a high level, its production mix is about 35% WTI oil, 18% Brent oil, 20% Alberta gas, and 19% European gas.

This translates to WTI oil contributing to about 51% of funds from operations, Brent oil contributing about 28%, and European gas contributing about 20%.

You’ll notice that Alberta gas is out of the picture, because gas prices are ridiculously low there. I’m thankful for its commodity diversification; Vermilion’s free cash flow contribution is divided among WTI oil (43%), Brent oil (29%), and European gas (28%).

question mark

Historically, Vermilion’s payout ratio (accounting for dividends and both sustaining and growth capital expenditures) has been as low as 59% and as high as 162% since 2003.

Depending on how severe the commodity price drops will be and how long they stay down for, Vermilion’s dividend may or may not be sustainable.

If the WTI price were at US$60 per barrel or higher, Vermilion’s funds from operations this year will have no problem covering its dividend and capital spending. However, when the WTI price drops to US$50 per barrel, that starts cutting into its growth capital. Assuming no growth capex, Vermilion can sustain the dividend even at a WTI price of US$40 per barrel.

As of writing, the WTI oil price sits at US$52 and change per barrel, which barely covers all the spending the company needs.

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Foolish takeaway

The fact that WTI is at about US$50 starts cutting into Vermilion’s growth capex. So, whether the 10.2% yield is sustainable or not depends on if management will decide to forgo growing production to protect the dividend.

From the company’s long history — 16 years — of keeping its dividend safe, management is likely to maintain the dividend with all its power. That said, it also depends on how low commodity prices will go and how long they will stay down for. If, for example, WTI stays at the US$30 level for an extended period of time, the company cannot possibility healthily maintain the dividend.

Vermilion Energy stock is trading at multi-year lows and is very attractive from a price-to-cash flow perspective, as it trades at a multiple of about 4.3, while its long-term multiple is about 8.6. Thomson Reuters’s mean 12-month target is $42.70 per share, which represents 58% near-term upside.

So, the high yield is not the only consideration. Outsized price appreciation is also in the cards, but investors need to have an above-average appetite for risk and be very patient.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng owns shares of VERMILION ENERGY INC.

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