Looking For High Yield In The Energy Sector

Includes: BTE, ESV, PGH, RIG, SDRL
by: Bayesian Investing

With two decades until retirement, I am more interested in the "growth" part of dividend growth investing. As such, most of my stocks have high dividend growth rates with an average -- or even below average -- current yield. However, I'm not going to let the yield hogs have all the fun; I do open smaller positions in a few higher-yielding names to juice my portfolio's average yield.

I am sure everyone is aware of the trade-off here: Higher yields tend to mean slower growth, or that the market is pricing in extra risk premium for that stock. I am looking for high-yield stocks that still have the ability to grow their dividend, offer an attractive risk/reward scenario, and offer exposure to a particular sector, country or theme that I am interested in.

The following is a list of stocks from the energy sector that are part of my personal high-yield portfolio, along with a brief discussion of the risks and rewards.

For a look into why I am so bullish on the energy sector, please see my previous article here.

Ecopetrol (ECP.TO)

The Company

Based out of Columbia, Ecopetrol is a vertically-integrated oil company and the fourth largest oil E&P company in Latin America. Ecopetrol has an income-and-growth business model where 70% of its free cash flow is paid out to shareholders through dividends and the rest retained for expansion. The company pays a very lucrative dividend yield of approximately 5.5%, is rapidly growing production, and is projected to have about 15% EPS growth over the next five years. The dividend should increase by the same amount.

The Reward

So if everything goes well, investors could be looking at a 20% total return annualized for the next five years, not to mention gain exposure to the fast growing economy of Columbia and their currency. A very attractive opportunity.

The Risks

I am not especially concerned about the risk of oil prices for Ecopetrol, although obviously, the higher the better. For their analysis, the company has been using an average oil price of $70. The price of oil is unlikely to drop that sharply unless there is a severe recession, in which case I will lock out my brokerage account and hide under my bed for a few quarters.

The biggest risk is that this is a nationally owned company. To be fair, successive Columbian governments have been very market-friendly, have not interfered with the company's governance and are slowly divesting themselves of their ownership in the company. Still, what one government gives another could take away. It should also be noted that while the security situation in Columbia is quite stable right now, there has been a history of drug cartels and other terrorists attacking state-owned energy infrastructure assets.

My Take

Given my belief in high oil prices and the fast-growing Columbian economy, I find the risk/reward scenario for this stock to be quite attractive. I have bought a few shares of ECP each year since they became available on major exchanges. Still, I am keeping my position size modest -- I am simply not willing to risk a huge part of my financial well being on a state-owned company, regardless of how market-friendly that state is currently acting.

Baytex Energy (NYSE:BTE)

The Company

If Ecopetrol is a little to risky for your personal tastes, consider Baytex Energy. This Canadian, mid-cap oil company is the model of stability. It has a collection of attractive oil producing properties across the WCSB and operates safe, low-cost drilling operations. Baytex also has a growth-and-income model, where it pays 50%-60% of their free cash flow in dividends and invests the rest to increase production.

Other former income trusts, like the more-followed Pengrowth Energy (NYSE:PGH), have stuck with the income-only model. As a result, the market frets with every dip in oil prices that the company won't be able to cover its generous dividend. Also, Pengrowth has rather anemic returns on equity and growth rates. By contrast, Baytex is embracing its conversion into a corporation: It initially lowered the dividend, but by retaining some operational cash to invest in organic growth, the company has managed to grow earnings enough to raise the dividend back to pre-conversion levels. The stock now offers a generous 5.2% yield that should grow every year.

The Reward

Baytex has stated the goal of increasing production by 8% annually through organic growth. This would result in a total return of about 13%-14% per year. Over the last eight years, Baytex has actually exceeded that goal: It has increased production by 12% annually and delivered a total return of around 25% per year.

The Risks

This is a very stable, conservatively run company with few risks. Along with general market risk, the largest factor affecting Baytex Energy's profitability is, of course, the price of oil. Specifically, the price that Western Canadian oil companies receive for their oil, which typically is at a discount to the oft-quoted WTI price. This discount has widened significantly this year due to a glut of oil coming from the oil sands and Bakken, along with refinery outages in Alberta.

My Take

I absolutely love this company's growth-and-income model and its attractive, stable oil assets. The stock price has been pounded lately based on the suddenly steep discount to WTI that companies like Baytex have been forced to endure. The price discount has already narrowed significantly as more companies use railways to ultimately export their oil to world destinations and reap the much more attractive Brent price. As well, Enbridge & EPD have a plan to increase pipeline capacity from Western Canada to American refineries that should be completed this summer.

Short-term problems offer the best opportunities for long term investors, so if you can handle a quarter or two of disappointing earnings, I would strongly urge you to build a position in Baytex Energy now.

Seadrill (NYSE:SDRL)

The Company

Despite being a relatively new company, European-based Seadrill is now the largest offshore driller in the world as measured by market cap. It accomplished this by throwing caution to the wind and quickly building a new drilling fleet, completely funded by debt. Seadrill now has a large fleet of rigs -- that I imagine must be the envy of the drilling community -- and enough debt to sink the titanic.

Consistent with its apparent devil-may-care attitude and despite its sea of red ink, Seadrill chooses to pay out almost all of their cash flow to shareholders as dividends and has a current yield of 8.5%.

The Rewards

For the life of me, I can't figure out why a highly indebted company, pursuing rapid growth and that has been cash flow negative for several quarters, is paying out all its operational cash flow as dividends. Still, its cash flow is adequate to service its debt and cover the dividend. Also, if day rates for ultra-deep water rigs continue to increase as they have been, that cash flow will increase quickly and Seadrill should have no problem paying down that debt. If things play out that way, it would make Seadrill an almost mythical creature: a very high-yielding stock that also has growth potential.

The Risks

There are so many risks here. For starters: This is a company whose financial plan was apparently written by a lunatic, operating in a highly cyclical sector. This is pretty far away from the typically stable dividend stocks operating in the utility or consumer goods sectors.

There is also significant liability risks from drilling accidents -- look at what happened to Transocean's (NYSE:RIG) stock after their little accident. Finally, of course, there is the risk of falling oil prices. Deepwater drilling is planned long in advance, so day-to-day fluctuations in oil prices are meaningless; however, a sustained, deep decline would put a quick halt to any growth in this industry. As a highly leveraged company, Seadrill would have trouble withstanding a slowdown in the industry.

My Take

The conservative, financial planner side of me is more naturally aligned with a steady, balanced company like Ensco (NYSE:ESV). Still, anyone who has followed my writing knows that I believe firmly in having a compelling investment thesis and then finding the best play for that thesis.

My investing thesis is that high oil prices, along with the decline of conventional oil production properties, will lead to sustained growth in deepwater drilling. The simple truth is that Seadrill, by far, is best positioned to benefit from increased demand in the ultra-deepwater drilling area.

While I will be carefully monitoring Seadrill's cash flow for signs of trouble, watching the trends of day rate prices for deepwater rigs and be on the lookout for signs of over capacity in this sector, I have bought a small position in the stock early this year and will add to it if there is a summer pullback. Despite the risks, Seadrill offers a potential for significant returns, so I will go along for the ride -- but I will also keep one hand on the sell button.

Disclosure: I am long EC, BTE, SDRL.

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