Growth-plus-yield model is the new norm for juniors

It isn’t just about growth anymore – now even small producers pay dividends

February 13, 2014

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The junior oil and gas model we used to know seems to have been relegated to the dustbin. That old model was built entirely on growth, which involved regularly raising capital through issuances of equity to fund fast-paced drilling programs with the intent of quickly growing a very small company into a larger one. Annual capital spending for these companies typically far exceeded internally generated cash flows.

This overspending of internal rates of cash flow worked: it resulted in impressive growth rates. Today, however, investors in the Canadian market have zero tolerance for leveraged balance sheets. A new plan is required, and it involves adapting to a model that investors prefer.

Welcome to the growth-plus-yield model. Now, when I say “growth” I’m not talking about the 30 per cent a year growth that companies were shooting for a few years ago, with the help of regular equity issuances. Now we are talking about a much lower growth rate of five to 10 per cent combined with a sensible dividend and a strong balance sheet. Dividends used to be common only for large and some medium-cap Canadian producers. Driven by investor demand, now even junior producers are doing it.

A perfect example of how things have changed is Cardinal Energy Ltd., which went public in December. Cardinal is run by Scott Ratushny, a manager that has had great success with the old junior growth business model. Ratushny has built and sold not one, not two, but five publicly traded companies. Despite this repeated success with the growth model, he has structured Cardinal Energy for a growth-plus-yield model from day one.

The key to building a small company capable of paying a dividend is selecting assets with very low decline rates. Low decline rates mean more free cash flow is available. Companies with higher decline rates have to reinvest almost all of their cash flow just to maintain current production levels, and have to wait longer for production to mature before dividend payments are in the cards.

What this means is that high decline, tight plays can’t be the focus for a junior producer interested in paying dividends. In Cardinal’s case, Ratushny has made several acquisitions of mature producing fields that have decline rates of 15 per cent or less. He’s betting Cardinal will only need to spend 60 per cent of cash flow to pay its dividend and sustain current production levels. That means the other 40 per cent can be used for acquisitions or growth drilling.

Cardinal’s launch in May 2012 as a private company was well-timed; as companies deleverage in increasing numbers, mature assets are becoming cheaper and more available. The trade-off for building a company made up of low decline, mature production is that Cardinal is not blessed with the decade of growth drilling locations that other growth-focused firms have. Cardinal is going to have to work harder to continually replenish its drilling inventory.

Cardinal Energy is going to start its life as a publicly traded company with roughly 5,800 barrels of oil equivalent per day production. Five years ago, a company of that size would never have even considered paying a dividend. Due to the current environment, Cardinal Energy likely never considered not doing so.

Scott Ratushny’s five companies show positive returns on all issued equity

1998 – 2002
Champion Resources Ltd.
Producing: Natural gas
Equity – $5 Million
Sale Price – $35 Million

2001-2004
Java Energy Ltd.
Producing: Natural gas and oil
Equity – $2 Million
Sale Price – $22 Million

2003-2005
Southpoint Resources Ltd.
Producing: Natural gas and oil
Equity – $19 Million
Sale Price – $42 Million

2004 -2008
Pilot Energy Ltd.
Producing: Oil
Equity – $13 Million
Sale Price – $76 Million

2009 -2012
Midway Energy Ltd.
Producing: Oil
Equity – $118 Million
Sale Price – $550 Million

Jody Chudley is the author of The Punchcard Portfolio, a value- oriented newsletter with a focus on Canadian oil and gas stocks.
Disclosure: No positions

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