Simple yet worthy advice In the following excerpt from the High-Yield Equity Securities Report, an expert analyst discusses the outlook for the sector for investors:
TWST: Are there certain characteristics that allow a company to be successful at paying a dividend?
Mr. Rawson: There are certainly characteristics that help make this work, although I wouldn't say there is a clear model that specifically spells out what you need to have to succeed as a dividend-paying company. The way that I look at it is you need to be able to generate free cash flow while keeping production at least flat, if not growing. In oil and gas, you are dealing with a declining asset base, and you need to continue to reinvest capital in the ground in order to keep that production flat.
So to make the dividend model work, I think you need to pay attention to three things. One is the base production-decline rate, another is the netback - that is the margin that you are generating on each barrel produced - and the third is the cost of production additions.
People tend to focus on the decline rate, and that's usually a good place to start. A low decline rate certainly makes it easier to generate free cash flow. But if a company has a low decline rate, but low netbacks and high cost of production additions, they still may not be able to keep up with declines while paying out a dividend.
High netbacks are definitely going to help you out. There are companies that might rank modestly on those two scales, but if they can make it up with very low cost of production additions and a good inventory of drilling locations, then you can make the model work.
Ideally, you would like all of those things, but typically you don't get all of them together. The other thing to note is that it is critical to have a realistic payout model from the beginning, retaining enough cash flow internally to replace production without having to rely on additional equity or growing leverage to make the business work...