Construct Your Oil Portfolio: Income Investing

by: Laurentian Research

This is Part 2 of a three-piece series aiming to take a long, hard look at how to go about building an oil stock portfolio that fits your personality.

An income stream can be created by assembling a portfolio of the Canadian monthly dividend payers and the MLPs in the U.S.

I showed how I treat dividend-paying oil stocks as variable rate bond and why some oil stocks are so attractive.

I explained how I manage the inflowing dividend stream.

"If you know that you are vulnerable to prediction errors, and… accept that most "risk measures" are flawed, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative." - Nassim Nicholas Taleb

Value investing in oil stocks

In Part 1 of the "Construct Your Oil Portfolio" series, I explored the differences between trend following and value investing and gave my view on how a momentum investor can adjust his holdings as the oil upswing unfolds so as to get the most bang for the buck. I stated in that article:

A value investor, on the one hand, attempts to determine the intrinsic value of a business behind the stock, on the other hand, uses the thus-derived intrinsic value as a yardstick to guide his entry and exit.

I divide the value investors into two camps, those who pursue a stream of income and those who are in it for capital appreciation. In this article, I intend to explore how a value investor may assemble a portfolio of stocks sourced from the oilpatch to produce a stable and growing stream of income.

The income investors

A value investor in search of a secure yet expanding income stream will find the Canadian monthly dividend payers and the upstream MLPs in the U.S. are fertile land to pick investment targets.

Some of these companies, with examples given below, have high-quality assets and strong cash flow, which enables them to pay dividends at high yield rates and to hike the dividends. Investors are paid to play the game of waiting for dividend increases and capital appreciation.

Examples of deep value dividend distributors

Granite Oil (GXO.TSX)(OTCQX:GXOCF) is an Alberta Bakken pure play (see here).

  • The company holds 381,554 gross (379,734 net) undeveloped acres and 55,082 gross (52,788) net developed acres, with 7.294 MMboe of Proven Developed Producing - aka, PDP - reserves, 14.302 MMboe of proven (1P) reserves, and 19.534 MMboe of proven and probable (2P) reserves as of December 31, 2017 (see here).

As I detailed at The Natural Resources Hub (TNRH), Granite currently trades at an incredible margin of safety of 68% (see here). That means, should the stock price reverse to the NAV, it will post a gain of 208%. As a matter of fact, the stock is poised to move higher now (Fig. 1). This three-bagger material pays monthly dividends at a dividend yield of 10.19%.

Fig. 1. Stock chart of Granite Oil. Source.

Bonterra Energy (BNE.TSX)(OTCPK:BNEFF) is a Cardium pure play in Alberta, the lowest-cost play in the Western Canada Sedimentary Basin.

  • The company holds a total of 221,186 net acres there, with the vast majority of properties in the Pembina and Willesden Green areas, with an average working interest of 76% while 88.5% of production is operated (see here and here).
  • As of end-2017, Bonterra has identified a total of 1,048 gross or 735 net Cardium drilling locations, which, based on 2017 production volumes of 12,827 boe/d, would provide 21 years of continued future development.
  • To date, less than 14% of the estimated 10.6 billion barrels of oil in place within the Cardium pool have been produced, providing for significant long-term development potential.
  • The company had 78.59 MMboe of proven reserves, of which 52% is PDP and 46% undeveloped; the company had 99.84 MMboe of 2P reserves, of which 62% is light to medium crude oil, 8% NGLs, and 30% natural gas (see here).

The company is estimated to offer investors a margin of safety of 33-54%. In other words, the investor stands to reap a 50-120% return, should the stock price reverse to the NAV (see here). The stock successfully retested the January 2016 low recently (Fig. 2). The company currently distributes monthly dividends at a dividend yield of 8.03%.

Fig. 2. Stock chart of BonterraEnergy. Source.

Cardinal Energy (CJ.TSX)(OTC:CRLFF) holds low-decline conventional oil properties in Alberta and Saskatchewan. As of December 31, 2018, the company had 78.08 MMboe of 1P and 103.78 MMboe of 2P reserves, which were up 58% and 54%, respectively, thanks to an acquisition. In 2017, the 2P finding and development cost was $12.67/boe and the operating netback came to $18.36/boe. The company produced around 21,000 boe/d, 87% in liquids.

The company is reckoned to offer investors a margin of safety of 49%, which implies, should the stock price reverse to the NAV, it will double. The stock has been building a base since July 2017 (Fig. 3). The company pays monthly dividends at a dividend yield of 9.15%.

Fig. 3. Stock chart of Cardinal Energy. Source.

Viper Energy (VNOM), a subsidiary of Diamondback Energy (FANG), is a Delaware limited partnership formed to acquire, own, and exploit oil and gas properties. It is in a transition to a taxable entity via a "check the box" election (see here).

  • The company currently holds mineral interests in properties in the Permian Basin, which are leased to working interest owners who bear the costs of operation and development. In 1Q2018, Viper has acquired mineral interests in 681 net royalty acres in the Eagle Ford, making a strategic entry in the play (see here).
  • The company's net royalty acres stood at 10,470 acres, 1P reserves 38.2 MMboe, and production 11,023 boe/d as of December 31, 2018, up 63%, 22%, and 71% year over year, respectively (see here).

The company currently pays quarterly distribution with a yield rate of 7.08%.

Additional prospects include Black Stone Minerals (BSM), which distributes at a yield rate of 7.13%, and Kimbell Royalty Partners (KRP), which pays at a yield rate of 6.29% (Table 1).

Table 1. A list of dividend-paying investment prospects for income investors. Source: the author.

These upstream MLPs form an ideal investment vehicle for income investors because of their unique business model:

  • These partnerships are exposed to exploration optionality by holding geologically prospective lands, on which they bear no direct carrying, exploration or development costs.
  • They have accumulated a greatly diversified portfolio, which reduces overall risk.
  • They face no resource capacity constraint to acquire more interests as an operating mining company does, which lends its business a scalability.
  • Without needing to attend to day-to-day operations, the management can focus on acquisition and growth.

These upstream MLPs are effectively free of the need to directly fund unscheduled mining capital expenditures and operating costs because they typically participate in the revenue line of operations without being directly impacted by cost inflation, thus capturing more torque from rising commodity prices. With low overheads, they are able to generate cash at high margin through the entire commodity cycle. Their economics is recapitulated in the following equation,

  • [Profit] = {[Royalty rate] X [Commodity price] - [Unit overhead]} X [Production]

Why deep value dividend payors?

The beauty of making an entry into these names now, when they are traded near their historical lows, is the ultrahigh dividend yield to be realized in the future once the business regains its vitality and restores the long-term normal dividends.

Consider Granite:

  • An investor of today pays US$2.12 for a share of the company to earn monthly dividends of US$0.018, which reflects a dividend yield of 10.19%.
  • Suppose the stock price rises to US$6.53 as dictated by the intrinsic value while the normal level of monthly dividends (US$0.035) is restored in two years. The investor will be receiving a dividend yield of 6.43%, not shabby but hardly impressive (Fig. 4).
  • However, if we treat this dividend-paying stock as a variable rate bond bought at US$2.12 per share, then the coupon rate will actually be 19.81%, which the investor receives on top of the 393% capital appreciation.

Fig. 4. The historical monthly dividends distributed by Granite Oil. Data sourced here.

What to do with the unspent dividends, if any?

One can either opt for the dividend reinvestment program (NYSEARCA:DRIP) or choose to direct the inflowing dividends into a low-cost mutual fund, such as Homestead Small Company Stock Fund (HSCSX) which has no minimum limit on each transaction of investment.

The purpose of using these tools as a depository of the dividends is to allow the stream of dividends to accumulate before they are deployed.

Investor takeaways

All income investors seek stable, high-yield, and growing dividends. However, there is no free lunch in investing; a high dividend yield may be a harbinger of a dividend cut or, worse, business distress down the road.

However, three years of oil industry depression have produced a plethora of deep values in the oilpatch, from which the income investors can pick the best-quality assets and derive an income stream from them.

To those who are still overly wary of the oil stocks, I'd like to say this: A high dividend yield means a totally different thing for an oil company entrapped in a commodity price downtrend and for an operator riding an oil upswing. The former probably will cut dividends, while the latter most likely won't.

I think it is an opportune time now to back up the truck with the best dividend payors from the oilpatch, notably certain Canadian E&P concerns that pay monthly dividends and some upstream MLPs in the U.S., which are the proverbial baby thrown out along with the bathwater.

The beauty of making an entry into these names now, when they are traded near their historical lows, is that the dividend yield, to be realized once the recovering business restores the dividends to the long-term normalcy, may reach incredible levels.

In the next article, the final piece in the series, I will discuss how an investor in search of capital appreciation may build an oil portfolio that delivers high-performance at a low risk.

Additional disclosure: For my full disclosure, please click here.

Disclosure: I am/we are long THE TNRH MODEL PORTFOLIOS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.