Volatility and divergence based on perceived risks were the key drivers of dividend-paying Canadian stocks’ returns in 2011. And energy producers were no exception.

The top performing Oil and Gas stock in the Canadian Edge How They Rate coverage universe threw off a total return of 202.4 percent. The worst performer, meanwhile, dropped nearly 70 percent. Eight stocks lost 30 percent or more.

As we enter 2012, investor fear of a 2008 reprise is as intense as ever. That means we can expect more volatility in these stocks on the basis of shifting perceptions alone. And that’s not including the companies that genuinely falter in the face of ups and downs in energy prices.

Consequently, successful investing will depend on being with the companies on the right side of the sector fault line, and avoiding those likely to be caught out just as much as it did in 2011. Below I first look at what happened in energy in 2011 and how it affected the Oil and Gas companies tracked in How They Rate. I examine the outlook for 2012 in Canada’s dividend-paying energy patch, including the key factors that will shape it.

I also highlight my formula for “staying liquid,” the key to sorting out the good from the bad and ugly in the sector. And I provide a list of my favorites, both inside and outside the CE Portfolio.

Gas Glut

Not since the late 1990s have natural gas prices been this low in the dead of winter. That includes the aftermath of the 2008 crash, when oil bottomed briefly under USD30 a barrel. US inventories of the clean fuel hit a record of 3.852 trillion cubic feet in November and remain at a record for December, 11.4 percent above year-earlier levels.

Heating demand that’s nearly 20 percent below normal so far this season is at least partly to blame. Roughly half of Americans heat their homes with natural gas. This shortfall has been offset somewhat by a jump in gas’ share of electricity generation to nearly 30 percent from an average of only about 20 percent in recent years.

Gas is increasingly popular with utilities and other power generators because it’s a quick way to get into compliance with tightening US Environmental Protection Agency (EPA) regulations on emissions of mercury, particulate matter and acid rain-causing gases. Gas-fired plants also emit less than half the carbon dioxide per kilowatt of power produced, they’re easy and economic to scale up quickly and they’re the best way to ensure adequate backup capacity in case notoriously erratic wind and solar plants don’t produce as expected.

In addition, gas is for the first time a much cheaper fuel than its arch rival coal. The latter’s price has benefitted from robust demand in countries such as China and India, which are still constructing huge new coal-fired power plants at a rapid clip.

All that’s likely to keep power companies in North America “dashing” for gas and demand for the fuel rising. Meanwhile, efforts to boost natural gas’ use for transportation are moving forward, providing another potentially major source of demand.

Finally, several new projects are underway to export natural gas to the rest of the world. One of these is a venture between Progress Energy Resources Corp (TSX: PRQ, OTC: PRQNF) and Malaysian national oil company Petronas. The latter is not only bankrolling Progress Energy’s efforts to expand gas production from a third-quarter 2011 rate of 42,900 barrels of oil equivalent per day (boe/d) to 100,000-plus by 2015. It’s funding the planned construction of a liquefied natural gas (LNG) export terminal, one of five such projects in various stages of development on British Columbia’s West Coast.

Encana Corp (TSX: ECA, NYSE: ECA), Shell Canada and Apache Canada are also funding projects in BC. Meanwhile, Dominion Resources (NYSE: D) is moving to equip its Cove Point, Maryland, LNG import terminal for exports, which would unlock Marcellus shale output for global shipping. So is Cheniere Energy Inc (NYSE: LNG), though its ability to bring a deal to fruition is in doubt due to extreme financial weakness and a recent 39 percent boost in projected project costs.

In short, demand for North American natural gas is on the rise and looks set to stay that way for years to come. Unfortunately for producers, rising usage–however impressive–is dwarfed by mushrooming supplies and production, made possible by the shale energy revolution.

According to the Energy Information Administration, US production of dry natural gas rose from 18.504 trillion cubic feet in 2006 to more than 23 trillion cubic feet in 2011.

That was partly offset by a drop in Canadian natural gas production from 6.6 trillion cubic feet in 2006 to 5.4 trillion in 2010. But here, too, volumes have started to pick up, as producers have discovered the joys of producing from shale, with BC leading the way and Alberta surging as heretofore untapped sources are exploited.

The key area so far has been the Montney Shale, which has spurred large output at several companies, including CE Aggressive Holding ARC Resources Ltd (TSX: ARX, OTC: AETUF). ARC and others have also set their sites on liquids-rich gas opportunities in Ante Creek and Pembina in Alberta, Parkland in BC and Goodlands in Manitoba. And many believe the Horn River Shale play will wind up dwarfing even these prolific finds.

All this gas is much less valuable to produce at sub-USD3 prices than it would be at USD5. One reason gas producers haven’t yet pulled in their horns is most have substantial hedge positions that lock in prices for much of their output at least through 2012. That alone is expected to keep North American output of gas growing next year, further boosting supplies.

Liquid Assets

In addition, gas is still worth producing at even lower prices, provided companies can extract natural gas liquids (NGLs) from it. NGLs are increasingly used as much less expensive substitutes for oil in a growing number of processes, including manufacture of plastics. And the ability to exploit liquids-rich gas from shale has unlocked enough new supplies to turn North America from energy importer to exporter.

The ongoing boom in NGLs could get a huge boost in coming years, should several large industrial and chemical firms follow through on plans to locate major new facilities in North America. Texas is one possible location, Alberta another.

NGLs are also benefitting from their close relationship with oil prices. Natural gas arguably began a bear market in late 2005, when the shut-in of Gulf of Mexico wells temporarily ran prices into the high teens. That encouraged both conservation and rapid development of gas reserves, which accelerated exponentially with the unlocking of shale gas production. Other than a brief spike in mid-2008 in the wake of oil’s push to more than USD150 a barrel, the fuel’s price has been falling ever since.

Oil too rose steadily in the early part of the decade but has been able to keep rising as global demand has risen, particularly in developing Asia. Even the Arab Spring and Japanese earthquake/tsunami couldn’t run black gold back to USD150 in 2011. But despite considerable volatility during the year, oil, as measured by West Texas Intermediate crude, still finished the year right around USD100 a barrel, more than USD10 above where it started. Meanwhile, Brent crude, which is the gauge for most of the world, was considerably higher throughout the year.

Strong oil prices are likely to remain a major plus for NGLs prices and profit margins in 2012, just as they were in 2011.

That, in turn, will make it economic for many companies to keep pumping all the natural gas they can from shale, as combined profit of selling with NGLs remains robust. And this is yet another factor pushing gas output up and prices down.

Such is the big picture right now for the dividend-paying Canadian producers of natural gas, NGLs and oil I track in How They Rate. More important, these are the conditions companies’ managements are gearing up to adapt to in 2012, and it will profoundly affect everything from their capital spending plans to the dividends they pay.

If anything was clear from the events of 2011, it’s that seemingly immutable conditions in the energy sector can and do change rapidly. An outbreak of real hostilities in the Persian Gulf, for example, would almost certainly trigger wild volatility in oil prices, even if there were no direct impact on actual oil production or supplies.

In addition, the Obama administration has become a major source of uncertainty for energy companies in both the US and Canada. A decision by the president on the Keystone XL pipeline proposed by TransCanada Corp (TSX: TRP, NYSE: TRP) still appears likely to be postponed until after the November presidential elections. That may shift the future market for oil sands from the US to Asia, as Enbridge Inc (TSX: ENB, NYSE: ENB) follows through on plans to build the Northern Gateway pipeline to the Pacific Coast. But Keystone XL’s delay and/or demise won’t slow oil sands development in Canada.

Recent moves by the EPA to increase scrutiny of hydraulic fracturing–known as “fracking”–do have potential to change the dynamics of the gas market. Fracking is the key to unlocking gas, gas liquids and oil from shale and involves shooting a mix of water (more than 95 percent), sand and what amounts to detergent at under ground rocks to create fissures to unlock the energy.

An outright national ban on the process such as France enacted last year would shut in a third of US gas supply, creating an instant shortage where a massive surplus now exists. That would leave the field to Canadian producers, who would immediately see a sharp rise in the price of their output.

That’s highly unlikely. What’s probable, though, is that states such as New York and Colorado will impose new environmental and safety regulations on companies using hydraulic fracturing. How much they inhibit drilling will depend on how far they go. To the extent these moves increase costs or slow production, Canadian producers will benefit.

Meanwhile, the EPA has announced a comprehensive study of drinking water and fracking, set to be completed in 2014, and will propose rules to force chemical makers to disclose products used in the process. Anything it does now regarding fracking could easily be reversed if Republicans gain control of the White House.

Moreover, President Obama has repeatedly endorsed greater use of natural gas as a way to speed energy independence and as a replacement for much dirtier coal in generating electricity. Both are currently impossible without the widespread use of hydraulic fracturing to produce oil and gas from shale.

Consequently, it’s unclear how far the EPA can or will go with its current scrutiny of fracking. It’s increasingly clear, however, that it will go after certain companies it deems in violation of health and safety regulations. This week, for example, the agency announced it will collect and sample water from wells in a Pennsylvania town near a gas-drilling site that used hydraulic fracturing. That follows the release of an EPA report blaming Encana for chemicals found in groundwater supplies in west-central Wyoming.

The key for Canadian producers is that whatever happens will push up costs for rivals operating in the US. And all else equal that would reduce output and supply, and eventually boost gas prices.

But again, the current environment for gas producers is one of massive supplies and very low prices, while the prices of oil and NGLs are strong. That’s the environment dividend-paying Canadian producers will be operating in for 2012. Though a spike in oil or a fracking ban in the US would be a bullish surprise, these are the assumptions investors should make before investing in these stocks this year.

Staying Liquid: Elements of Success

Given the strong price performance of oil and NGLs, the weakness of natural gas and the likelihood for more of the same in 2012, it might seem obvious investors should focus on oil-weighted producers, and dodge gas-focused companies. That, however, was no guarantee of success in 2011.

Check out “Liquid Returns,” which compares 2011 total returns (dividends plus capital gains or loss) of the six most oil-weighted companies in tracked in How They Rate. Baytex Energy Corp (TSX: BTE, NYSE: BTE) did post a respectable gain after rallying strongly at the end of the year. But the rest managed only meager gains or outright losses.

PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) was off nearly 40 percent including dividends. And that was only after a 125 percent gain from early October to the end of the year. In short, it was a good time for some oil producers. But most suffered flat to negative returns.

As for the converse–avoid all gas stocks–that, too, proved off the mark in 2011. Check out “Gas Burdened,” which shows total returns for the most heavily gas-weighted producers in How They Rate.

To be sure, there were big losers in the group. Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) was forced to eliminate its dividend as natural gas prices plunged far below the projections management was basing guidance on. Lower gas prices have also raised questions about its ability to service debt maturities.

Ditto Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV), which cut production 4.9 percent in the third quarter from year-earlier levels. That reversed a trend of robust increases thanks to success exploiting Montney Shale properties. Even giant Encana took a big hit, as crashing gas prices raised questions about whether it would have to curtail its ambitious expansion plans.

On the other hand, the graphic also details the two best performing producers in How They Rate for 2011, namely Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) and Trilogy Energy Corp (TSX: TET, OTC: TETZF). In fact both of these stocks were basically strong throughout the year, even as the rest of their sector often ratcheted up and down violently.

In November 2010 I wrote a feature article titled Energy: Focus on Output. I highlighted a basket of CE Portfolio producers investing in expanding oil and gas reserves and production as the best way to build wealth in the sector, including ARC Resources, now acquired Daylight Energy Ltd, Enerplus Corp (TSX: ERF, NYSE: ERF), Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE), Peyto Exploration & Development and Vermilion Energy Inc (TSX: VET, OTC: VEMTF).

All of them are still Portfolio members. And since then I’ve added Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF) to their ranks. Not all of them had a stellar 2011. But the six did eke out a small gain and as a result vastly outperformed all but a handful of How They Rate companies.

Moreover, the extent to which they were successful was largely attributable not to what they produced but how successful they were growing output and reserves. Peyto’s almost unbelievable 41 percent boost in its gas-weighted production made it the No. 2 performer, second only to Trilogy Energy, which had a bigger gain largely because the stock was coming from a lower baseline valuation.

Looking outside the Portfolio core group, the impact of production gains on results is even starker. PetroBakken stock, for example, was having an horrific year up until early October, falling from a little over CAD23 in early March to a low of CAD6.

The reason was production numbers that were well below analyst expectations and company guidance. Once management was able to put up better numbers, the stock was off to the races.

“Production’s Dividends” shows the 2011 performance of the companies in How They Rate with the largest percentage output growth for the 12 months ended Sept. 30, 2011.

The only real exception to the trend was Equal Energy Ltd (TSX: EQU, NYSE: EQU), which was burdened by debt concerns. The rest performed much better than the average How They Rate producer, even little AvenEx Energy Corp (TSX: AVF, OTC: AVNDF), which rebounded sharply following the release of third-quarter numbers that showed a big rebound in production growth.

The upshot is the ability to grow production and reserves was the key factor determining producer performance in 2011, and it’s likely to remain extremely important in 2012 as well. The trick for investors is to separate the companies that can do it from those that will be overwhelmed by a volatile price environment, debt concerns or just bad operating management.

Where the Buys Are

A generally flat to down-trending performance in 2011 has left most Canadian energy producers priced for low expectations. At the same time managements of most companies have maintained conservative outlooks and policies regarding expansion of operations, balance sheet strength and paying dividends. Payout ratios as of third-quarter earnings, for example, were quite low as can be seen in How They Rate.

Dividend risk based on these numbers is actually pretty low across the sector. The wildcard, however, is how they’ll be affected by the fourth-quarter crash in natural gas prices that’s left them more than a third lower than a year ago.

We won’t have the answer to that in the numbers until companies release fourth-quarter and full-year numbers. And since those include year-end filings, some companies won’t be giving them to us until March.

Long before that, however, management will be aware of a lot we aren’t regarding cash flow and companies’ ability to cover their capital needs.

We could see some companies cut their dividend in response to falling natural gas prices long before we’re able to see weakness in the numbers. That’s the primary reason I’ve downgraded so many sector stocks to hold and even sell this month, including most gas-weighed companies, as a precaution.

One company I’ve downgraded to hold is Enerplus. The company announced this week that it has achieved its exit production guidance for 2011 of 82,000 boe/d. That’s in large part due to the success of its Bakken tight oil resource play, which saw output rise 26 percent from the beginning of the year to 17,000 boe/d. Marcellus Shale output also rose sharply despite the sale of certain non-core properties.

Management’s focus on developing Bakken and parallel efforts in liquids development in Canada are steadily shifting the production mix away from natural gas. The latter, however, is still a little more than half the total, which has me a bit concerned about what fourth quarter and 2012 cash flows will look like.

Enerplus’ financial management has been extremely conservative in the face of rebounding energy prices the past couple years, as it’s continued to whittle away at debt. As a result, though capital spending plus dividends currently exceeds cash flow, the company has no debt maturities until 2014 and as of September had CAD735 million left undrawn on a CAD1 billion credit line. Debt-to-annualized cash flow at the end of the third quarter was the lowest in the sector at just 0.7-to-1.

The key is just how much lower cash flow will be after the drop in gas prices. Management has certainly proven itself able to adapt to conditions in the past, and odds are it will this time around as well. But until we see what the damage to cash flow is–and whether or not gas prices can stabilize here at USD3 per million British thermal units–Enerplus is a hold.

Conservative investors should also steer clear of any producer with hefty debt maturities in 2012, particularly if the company is weighted toward natural gas production. NAL Energy Corp (TSX: NAE, OTC: NOIGF) has CAD302 million drawn on a CAD550 million credit line that matures on Apr. 30, 2012. In addition, some 64 percent of its output is natural gas, which may be making its lenders nervous and in the mood to demand concessions.

We may learn more about the company’s plans when it releases 2012 operating and financial plans next week. Until then a dividend cut is a distinct risk. NAL Energy is a sell.

I’m also maintaining a sell on Perpetual Energy, which has CAD173 million in debt that must be rolled over or paid off. That will severely test management’s skill appeasing its bankers.

The question is which Canadian energy producers are worth buying now. The best are still companies that can increase production, rely more on liquids to reduce exposure to falling natural gas prices and have limited their debt exposure.

Dividends of all producers are always at the mercy of energy price swings to some extent.

That’s why I have these stocks in the Aggressive Holdings, and every investor who buys them needs to recognize they own an energy stock whose fortunes can fluctuate.

That being said, companies that can boost output and maintain strength in this environment should throw off solid returns in 2011.

This list includes ARC Resources, AvenEx Energy, Baytex Energy, Bonterra Energy Corp (TSX: BNE, OTC: BNEUF), Canadian Oil Sands Ltd (TSX: COS, OTC: COSWF), Cenovus Energy Inc (TSX: CVE, NYSE: CVE), Crescent Point Energy, MEG Energy Corp (TSX: MEG, OTC: MEGEF), Pengrowth Energy Corp (TSX: PGF, NYSE: PGH), Penn West Petroleum, Peyto Exploration & Development, Talisman Energy Inc (TSX: TLM, NYSE: TLM) and Vermilion Energy.

The main problem investors are going to have with these stocks is they often trade above my buy targets. But those who are patient and buy on the off days should have plenty of opportunities to scoop them up at bargain prices.

Over the next few months all of these companies will release independent evaluations of their reserves. When these numbers come we’ll be able to get a read on how their market values stack up against what’s in the ground. I’ll be reporting the highlights in regular issues of Canadian Edge and in Flash Alerts as needed.

What makes these companies special going into 2012 is their ability to boost production going forward. Should they at any time fail at that task, I’ll be kicking them off the list. Equally, if a company like Enerplus proves it can still execute its plans despite the drop in gas prices, I’ll be boosting it to a buy again. That way, we’ll have the best chance of realizing strong returns in these stocks this year, while avoiding those at risk to blow-ups and dividend cuts.