In an interview with Financial Times published on March 30, 2015, Bank of Canada Governor Stephen Poloz warned that the steep decline in crude oil prices since June 2014 is having an “atrocious” effect on the Canadian economy.

The next day, Statistics Canada reported that gross domestic product (GDP) shrank by 0.1% in January, better than a consensus estimate of a 0.2% contraction and a marked improvement on the 0.3% decline for December 2014.

Solid growth in manufactured goods output offset pullbacks in wholesale trade and retail sales.

It appears Canada’s economy has suffered the negative effects of oil’s slump and a particularly bitter winter much less than experts feared.

The Cure for Low Prices
Is Low Prices

In the first six months of 2014, North American crude oil and natural gas prices reached their highest levels on average since 2008. Strong prices contributed to significant drilling activity in North America, resulting in supply growth of both crude oil and natural gas.

Increased supplies created imbalances in the market, and prices for both crude oil and natural gas slid, dramatically, over the second half of 2014.

Over-supply in the oil market became more apparent late in 2014, with the continued production growth from shale plays in the U.S., slower-than-expected global demand growth and sustained production levels by OPEC.

The selloff in global oil prices was a market reaction to restore balance, given that OPEC didn’t reduce production.

Current oil prices are below marginal supply costs for new production from many areas; the current depressed prices have resulted in a significant reduction in 2015 budgeted capital spending for the global energy sector.

Reduced drilling activity should slow supply growth and re-balance markets, though there will be a significant time lag between drilling activity levels and resultant oil production due to the lifecycle of well completions and tie-ins.

The decrease in drilling activity should also lead to lower oilfield service costs, which should result in improved rates of return at lower commodity prices and a more efficient energy sector.

For natural gas, 2014 started with a cold winter that established record-setting demand. Depleted inventory levels supported prices above USD4 per million British thermal units for the first six months of the year.

As was the case with oil, U.S. natural gas supply levels increased during the second half of 2014, boosting inventories to levels capable of satisfying 2014-15 winter heating demand.

At the same time, the devaluation of the Canadian dollar versus the U.S. dollar partially offset the impact of lower U.S. dollar-denominated crude oil and natural gas prices.

The chart reveals a steep decline for crude oil. But the net effect for Canada has been muted. Canadian synthetic crude, a light oil upgraded from bitumen extracted from the oil sands, traded at a USD3.75 premium to West Texas Intermediate (WTI) on April 9, 2015, the biggest premium since April 30, 2014.

And Western Canadian Select, a heavy oil and the benchmark for oil sands producers, traded at a USD11.90 per barrel discount to WTI, the narrowest spread in 22 months.

How We Rate

Our primary concern with our oil-and-gas-focused Portfolio Holdings is dividend sustainability throughout commodity price cycles.

Low payout ratios, strong balance sheets, consistent production and reserve growth and competent management characterize the four buy-rated oil and gas producers in the CE Portfolio Aggressive Holdings.

Crescent Point Energy Corp (TSX: CPG, NYSE: CPG) demonstrated its ability to manage cash flow during the severe commodity-price downturn that accompanied the 2008-09 Global Financial Crisis/Great Recession.

The per-barrel price of crude declined by 77% from its July 2008 top to its December 2008 bottom. Crescent Point actually raised its monthly dividend rate from CAD0.20 to CAD0.23 in June 2008 and has maintained that level ever since.

Management reported a 17.1% increase in 2014 production to 140,803 barrels of oil equivalent per day (boe/d). Funds from operations per share were up 8.3% to CAD5.72, resulting in a payout ratio of 48.3%.

The fourth-quarter payout ratio, which reflects the impact of lower oil prices was 53.9%, still a manageable level that allows Crescent Point sufficient flexibility to fund current production operations as well as its exploration program.

Crescent Point also employs an aggressive hedging strategy. As of Feb. 24, 2015, 54% of the company’s forecast 2015 oil production was sold forward at average prices of more than USD89 per barrel.

Crescent Point, which is yielding 9%, the highest among our four oil and gas favorites, is a buy under USD28.

Peyto Exploration & Development Corp’s (TSX: PEY, OTC: PEYUF) primary line of defense against falling commodity prices is a cost structure that’s among the lowest in the oil and gas sector.

By focusing on costs, rather than revenues, Peyto helps insulate itself from the volatility in prices inherent in a commodity business. The company has been able to maintain profitability throughout various commodity price cycles over the past decade-plus.

Peyto also owns land, production and processing assets, which provides an additional cushion against commodity price volatility.

Production for 2014 was up 28.7%, while FFO per share surged 47.2%. The full-year payout ratio was just 26.3%, though it ticked up to 28.3% for the fourth quarter.

Peyto, which is yielding 3.8%, is a buy under USD38.

Note that fourth-quarter and full-year 2014 financial and operating results for buy-rated ARC Resources Ltd (TSX: ARX, OTC: AETUF) and Vermilion Energy Inc (TSX: VET, NYSE: VET) are discussed in the March 2015 Portfolio Update.

ARC’s full-year and fourth-quarter payout ratios were 33.9% and 38%, respectively. A crucial element of ARC’s story, in addition to an active hedging program that supports stable and predictable revenue, is management’s successful effort to drive operating costs lower.

Average costs in 2014 were CAD8.88 per boe. But its key Montney play showed production costs of just CAD5 per boe. And the trajectory for 2015 and 2016 points to further improvement, though management has provided conservative guidance of CAD8.80 to CAD9.30 per boe for the current year.

A strong balance sheet and capital flexibility also support the current dividend rate of CAD0.10 per share per month. ARC Resources, which is yielding 5.4%, is a buy under USD28.

Vermilion paid out 33.8% of full-year and 37.3% of fourth-quarter FFO. It’s a premier defensive name for oil and gas investors, with a solid combination of yield and growth supported by its globally diversified production.

Its unique commodity exposure, particularly to European gas prices, in addition to a strong balance sheet and conservative financial practices support the current dividend rate.

Vermilion Energy, which is yielding 4.7%, is a buy under USD54.