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Oil and gas companies are often common picks for dividend investors. They generally provide above average dividends as well as overall inflation protection, depending on their specific industry. I previously wrote an article that highlighted 17 such stocks. The focus was simply to review some of the top dividend payers in the industry. However, that type of analysis is just a first pass look. The stocks should offer varying valuation levels based on different metrics. At first glance, some might seem overvalued while others might seem undervalued.

Simply chasing high yields is not a great strategy. One has to also consider the risk associated with the investment and the potential upside. Furthermore, dividend yields are just one aspect of a stock's total return, where total return for a year can be thought of as the percent price appreciation plus the dividend yield. A 5% dividend yield is hardly adequate if the stock price drops by 10% or even shows less price appreciation than other companies in that sector.

Risk is a pretty generic term and since the goal here is to simply screen stocks, I'll just use beta as the measure. Beta is a measure of stock's systematic risk. Beta reflects the volatility and correlation of a stock relative to the broader market. I often just use SPDR S&P 500 Trust ETF (NYSEARCA:SPY) for this purpose. Stocks with higher betas, i.e., more risk, should require greater returns or hurdle rates. The hurdle rate can be calculated using the capital asset pricing model which posits that the hurdle rate is the risk free rate (typically, a 10-year U.S. Treasury bond is a good proxy), plus the beta multiplied by the equity risk premium. I typically use 6% as my equity risk premium. Different research has suggested higher and lower risk premiums.

Growth is also a pretty generic term and in this case refers to 5-year/ long term earnings per share growth. I previously looked at the following companies:

Oil and Gas Companies

Ticker Name Market Cap ($ millions) Dividend Yield (%) Industry
RDS.A Royal Dutch Shell plc 221,810 4.9% Integrated Oil & Gas Firm
TOT TotalFinaElf, S.A. 128,674 4.3% Integrated Oil & Gas Firm
TRP Transcananda Pipelines, Ltd. 27,436 4.1% Production and Pipelines
SE Spectra Energy Corp 16,885 4.0% Services and Pipelines
E ENI S.p.A. 94,266 4.0% Integrated Oil & Gas Firm
COP ConocoPhillips 107,724 3.5% Integrated Oil & Gas Firm
ENB Enbridge Inc 22,609 3.3% Production and Pipelines
UGP Ultrapar Participacoes S.A. 8,602 3.0% Production and Pipelines
STO Statoil ASA 86,283 2.9% Integrated Oil & Gas Firm
CVX Chevron Corporation 206,366 2.8% Integrated Oil & Gas Firm
BP BP p.l.c. 141,318 2.8% Integrated Oil & Gas Firm
ESV ENSCO plc 7,940 2.5% Oil & Gas Drilling
ECA Encana Corporation 25,089 2.3% Oil Exploration and Production
EC Ecopetrol S.A. 81,350 2.3% Integrated Oil & Gas Firm
XOM Exxon Mobil Corporation 400,903 2.2% Integrated Oil & Gas Firm
CVE Cenovus Energy Inc 27,713 2.2% Integrated Oil Firm
MRO Marathon Oil Corporation 35,296 2.0% Integrated Oil & Gas Firm

Data is provided by Zacks.com services. Market capitalizations and dividend yields are current as of March 18, 2011. RDS.A data is from Google.com and current as of March 21, 2011.

Analysis

This analysis will rank the stocks from dividend yield with an adjustment for growth (which increases the attractiveness of the stock) and hurdle rate (higher hurdle rates reduce the attractiveness of a stock). Furthermore, for an investor focused on current income, a low hurdle rate with a high dividend yield suggests that most of the returns from that stock will come in the form of dividends and not price appreciation.

Hurdle Rates

Ticker Beta Risk Free Equity Risk Premium Hurdle Rate
MRO 1.18 3.32% 6.00% 10.4%
ESV 1.17 3.32% 6.00% 10.3%
COP 1.16 3.32% 6.00% 10.3%
STO 1.13 3.32% 6.00% 10.1%
BP 1.09 3.32% 6.00% 9.9%
UGP 1.02 3.32% 6.00% 9.4%
ECA 0.95 3.32% 6.00% 9.0%
RDS.A 0.94 3.32% 6.00% 9.0%
E 0.94 3.32% 6.00% 9.0%
TOT 0.90 3.32% 6.00% 8.7%
SE 0.90 3.32% 6.00% 8.7%
EC 0.83 3.32% 6.00% 8.3%
TRP 0.78 3.32% 6.00% 8.0%
CVX 0.75 3.32% 6.00% 7.8%
ENB 0.68 3.32% 6.00% 7.4%
XOM 0.48 3.32% 6.00% 6.2%
CVE 0.18 3.32% 6.00% 4.4%

Source: Yahoo!Finance for 10 year treasury bond yield. Data is provided by Zacks.com services for the betas for each stock. Yahoo!Finance was used for RDS.A's beta.

The first step is to look at hurdle rates. The current 10 year Treasury bond yield is 3.32%. The first observation is that the hurdle rates are largely clustered together around 7% to 10%. The second observation is that there are a few outlier hurdle rates due to low betas for XOM and CVE.

Next, the hurdle rate is compared to the dividend yield and projected growth. The goal is to maximize dividend yield + growth - hurdle rate. I often just refer this to the DRG Index. One key issue is that the dividend yield needs to be grossed up to approximate next year's dividend yield.

Balancing Risk and Growth Against Dividend Yields

Ticker Hurdle Rate Forward Dividend Yield Growth DRG Index (DY + G - HR)
EC 8.3% 2.6% 24.5% 18.8%
UGP 9.4% 3.3% 20.0% 13.9%
ENB 7.4% 3.7% 9.4% 5.7%
CVE 4.4% 2.3% 7.0% 4.9%
TRP 8.0% 4.4% 8.0% 4.3%
ESV 10.3% 3.4% 10.5% 3.6%
RDS.A 9.0% 4.9% 3% to 8% -1.1% to 3.9%
XOM 6.2% 2.4% 5.1% 1.2%
SE 8.7% 4.2% 5.5% 1.0%
CVX 7.8% 3.1% 5.6% 0.8%
ECA 9.0% 2.8% 7.0% 0.8%
COP 10.3% 3.8% 6.6% 0.2%
TOT 8.7% 5.3% 3.0% -0.4%
E 9.0% 4.0% 3.0% -1.9%
BP 9.9% 3.2% 4.0% -2.7%
STO 10.1% 3.1% 4.0% -3.0%
MRO 10.4% 2.1% 1.6% -6.7%

Data is provided by Zacks.com services and is the long term EPS estimate. ENB, TRP and UGP Earnings growth provided by Yahoo!Finance and is the 5 year estimate. RDS.A growth entered as an estimated range.

Issues

This analysis is a starting position to completing fundamental analysis. One obvious consideration is that the growth required is the long term growth and growth entered is the 5 year EPS growth. The very high growth companies should eventually slow down. The other key consideration is that high growth is probably already priced into the stock to a certain extent.

Ranking with P/Es

Ticker Growth DRG Index Current Fiscal Year P/E Estimate
EC 24.5% 18.8% 14.9x
UGP 20.0% 13.9% 16.0x
ENB 9.4% 5.7% 20.5x
CVE 7.0% 4.9% 24.1x
TRP 8.0% 4.3% 17.3x
ESV 10.5% 3.6% 15.0x
RDS.A 3% to 8% 1-1.% to 3.9% NA
XOM 5.1% 1.2% 10.8x
SE 5.5% 1.0% 15.1x
CVX 5.6% 0.8% 9.0x
ECA 7.0% 0.8% 49.6x
COP 6.6% 0.2% 10.3x
TOT 3.0% -0.4% 8.0x
E 3.0% -1.9% 7.6x
BP 4.0% -2.7% 6.7x
STO 4.0% -3.0% 9.7x
MRO 1.6% -6.7% 9.9x

Data is provided by Zacks.com services.

The analysis should also be considered within industry groupings: Pipeline companies are fundamentally different from exploration and production companies in their risk profile and hurdle rates. Furthermore, companies with a smaller geographic focus may carry additional risks than larger companies. A CVE with higher exposure to Canadian oil sands may have a different risk profile despite a lower beta. Furthermore, it looks really good due to a very low hurdle rate - a rate that probably deserves additional scrutiny.

Conclusion

Just chasing yield potentially does not find the best overall opportunity. By balancing yield with risk and growth, the rankings change and suggest that EC and UGP are better than TOT and E-- which would be ranked more highly when just looking at dividend yield. The P/E ratios suggest that these two stocks carry reasonable valuations.

Furthermore, an RDS, despite having the highest dividend yield, is just in the middle of the group when risk and growth factors are also considered.

Disclaimer: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Source: Balancing Growth and Risk for These 17 Oil and Gas Dividend Stocks