Canadian Natural Resources Stock: My Only Dividend Growth Investment (NYSE:CNQ) - Seeking Alpha

Canadian Natural Resources Stock: My Only Dividend Growth Investment (NYSE:CNQ) | Seeking Alpha

Canadian Natural Resources: My Only Dividend Growth Investment

Canadian Natural Resources Limited (CNQ),
CNQ:CA 11 Comments

Summary

- Canadian Natural Resources is a major producer of oil from the Canadian oil sands, a long-lived and low-decline source. They also produce other types of oil and natural gas.
- They have reached a stage where ongoing cash flows support gradual expansion of production and will support 100% returns of all other cash to shareholders within a year.
- Ballpark forward returns look like a midcycle dividend yield of 9%, growing at 5%.
- I do much more than just articles at High Yield Landlord: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

Phototreat

This article continues my plan to write one thorough article per year on nearly all of my portfolio holdings. Up next is Canadian Natural Resources (NYSE: CNQ), which I last wrote about 18 months ago. I often remark that it is the only Dividend Growth stock in my portfolio.

No wonder, since their long-term CAGR of dividends is above 20%. That becomes significant when the base dividend yield is near 5%, as it is today. And that is before the special dividends that are part of the plan, not to mention ample share buybacks.

Most of my CNQ was purchased in late 2021 and has a paper gain near 41% not counting dividends. The minority purchased early this year has a paper loss of 3% at the moment. My overall paper gain stands at 21%.

This matters little, though, since I have no intention to sell. My dividends to date on that first tranche are already above 10% of what I paid.

One must ask, though, what the CAGR of the dividend will be going forward. The dividend itself is already large.

First the Risks

Before we take that up, let’s discuss risks. The reason for putting this first is that the risks are not economic.

Canadian Natural will be profitable at any reasonable trough in oil prices and tremendously profitable at midcycle prices. More on that below.

The risks are related to politics. Production from the oil sands are a big part of the story here, and the oil sands have had a pretty negative reputation.

Today all the major oil-sands producers have been working together and are on a path to net zero. Significant progress has already been made. Here is the slide about future plans:
Canadian Natural Resources

Now the progress and plans will not dissuade those who have developed a religious objection to fossil fuels. If this were to carry the day, it would be extremely negative for oil-sands investments. To my mind, three general themes weigh against this.

First, the magnitude of the challenge of doing a rapid energy transition is becoming increasingly evident. The dream that such a transition could be quick or cheap has proven to be nothing but a fantasy.

Enterprise Products Partners ( EPD) routinely covers why in their investor presentations. See for example pp. 31 to 38 in this one.

Second, the Canadian Province of Alberta is essentially dependent on the fossil-fuel industry to support itself financially. And provinces carry more weight in Canadian national politics than states do in US national politics.

Third, fossil fuels are essential for all four pillars of civilization (ammonia, steel, cement, and plastics) identified in Vaclav Smil’s “How the World Really Works.” That book includes a very nice segment on the large quantity of oil used so that a vegan fossil-fuel opponent can enjoy a tomato for lunch.

So while it could happen that the rest of Canada will agree to kill off Alberta in pursuit of an impossible fantasy, having this really come to pass seems very unlikely to me.

The Main Story

Canadian Natural produces oil and gas across the Western Canada Sedimentary Basin, or WCSB. The WCSB is a geologic miracle providing many decades of inventory to firms that hold good assets there.

First we focus on the largest source of production by Canadian Natural. This is Synthetic Crude Oil or SCO. According to Oil Sands Magazine,

Synthetic Crude Oil is a light sweet crude produced through the upgrading of bitumen. SCO is typically a blend of naphtha, distillate, and gas oil streams from the hydrotreater. The term "synthetic" distinguishes upgraded bitumen from conventional crude, although the two streams are chemically identical. Since synthetic crude is light and sulphur-free, it can be sold to a conventional (less complex) refinery. Synthetic crude represents about 35% of Alberta's production. There are four SCO producers in Alberta — Syncrude, Suncor, Canadian Natural Resources and Shell.

SCO prices are typically above the price of WTI crude. This is a sharp contrast with pricing of WCS heavy crude.

SCO is 35% of the barrels of energy, or BOE, produced by Canadian Natural. The contribution to revenues is larger; for Q1 2023 SCO was 42% of product sales.

But to be able to produce SCO requires massive capital investments. One needs not only the oil-sands mining facility, but also an “Upgrader” to remove sulphur and other impurities and produce the oil that behaves like conventional light crude.

Canadian Natural decided well over a decade ago to make the investment. One can see how this played out in the history of their cash flows:
RP Drake

The bars are all normalized to adjusted funds flow. Adjusted funds flow represents the cash generated by the business. The adjustment takes out noncash changes in working capital, which make Cash from Operations give an inaccurate picture.

Here the red bars show the capital expenditures. These were enormous, sometimes above 100% of adjusted funds flow, from before 2010 through 2017.

By the end of 2016 they were able to announce that the most difficult phase was complete. The capex has decreased since and now, at about $5B per year, is sufficient to sustain overall production and grow it slowly.

Toward the end of the high-capex phase, they began to add debt, shown by the blue bars. Then they purchased the Athabasca Oil Sands Project mines from Shell, adding more debt to do so in 2017.

After establishing themselves in oil mining in those two ways, Canadian Natural began to systematically pay down debt. The yellow bars show net debt repayments.

Today the debt is at about $12B, headed to $10B within a year. That has more significance, discussed below.

Over the same period, they began to ramp up share repurchases, shown by the purple bars. These have been comparable to the dividend payouts, shown in green, for the past two years. Much more on this later, too.

Lots of Other Stories

Beyond mining the oil sands, Canadian Natural produces several other types of hydrocarbons. Their summary of daily production during Q1 is informative:

Canadian Natural Resources

You can see that natural gas is 27% of the total BOE/d. They are the second largest natural gas producer in Canada. But because gas prices are so low now, it contributed only 10% of gross revenue (bottom row).

The second largest liquids source is bitumen, which also comes from oil sands. They have a couple of ways to harvest oil from the bitumen, summarized in my previous article.

That said, I encourage you to peruse their investor presentation. This is an incredibly innovative company, which continues to result in lowering production costs and reducing environmental impacts.

Overall, products originating in the oil sands make up 59% of liquids production and more than 50% of gross revenue. The remaining production comes in three diverse categories, as shown.

The realized wellhead prices for the oil other than SCO are shown in this next table. The weighted-average, realized sales price for (non-SCO) crude oil and NGLs was $59, while that for the SCO was $96.

Canadian Natural Resources

As various types of production become more or less profitable, the combination of six products enables diversification of production and growth. As an example, they indicated recently that they will respond to the low price of natural gas at present by drilling fewer wells of that type for the next year.

Seeking the Future

To look ahead, it helps to focus on more recent cash flows. The next graphic can help us do that.

RP Drake

This is worth taking some time on. The first 6 pairs of stacked bars each give TTM cash flows from Q1 of the year in question. The final pair annualizes Q1 2023. Now let’s see what the bars show.

The left stacked bar of each pair shows sources of funds. The green bars are adjusted funds flow. The other sources of cash are debt issued (gray) and stock issued (red), of which there is almost none, especially in recent years.

The sources of funds are completely dominated by adjusted funds flow. This is not a company raising capital from the capital markets to support growth.

The right stacked bars of each pair show uses of funds. What is most consistent is the yellow bar, showing capex. As discussed above, this has stabilized.

The blue bar is the dividends. This has increased recently with increasing adjusted funds flow. For the annualized Q1 2023 dividends, 38% is the base dividend and 62% is the special dividend that was paid.

That rightmost blue bar is likely too large to represent what all of 2023 will turn out to be. Canadian natural is making good profits this year but they are still a lot smaller than those of 2022.

Above the blue bars are the orange ones, showing buybacks. With the market cap being only $60B, these lately are very material. They were near 10% of the float in 2022 and may be 5% this year.

Think about what that implies. If you buy back 10% of the float, then you can raise the dividend 10% and spend the same amount of funds on the dividend as you did the year before.

What’s more, per share earnings will go up 10%. So if the market gives you the same earnings multiple (far from guaranteed), the price will go up 10% and the dividend yield will stay the same.

The Capital Allocation Plan

At this point we can see the main elements of sources and uses of cash. The question is what Canadian Natural will do going forward.

They’ve told us what they plan, in their current investor presentation:

Canadian Natural Resources

Right now the net debt is just below $12B, having come down substantially during the past year. Once it reaches $10B, late this year or early next year, the box on the right describes the capital allocation policy.

At that point, Free Cash Flow after all capex and (base) dividends will go 100% to shareholders, through some combination of buybacks and special dividends.

Dividend Growth

It seems to me that the dividend is now too large a fraction of adjusted funds flow to keep growing at the historical rate above 20%. Let’s look at what might be feasible.

The ballpark range of adjusted funds flow across a cycle of oil prices is $10B to $20B. Capex will stay near $5B, providing maintenance capex and enough growth capex to grow production 5% per year. The base dividend costs just under $4B.

So at the low point of the cycle there will be just a bit of additional returns to shareholders and at the high point these may exceed $10B. A midpoint expectation for the additional returns might be $5B.

This $5B would support buying back 4% of today’s Market Cap and paying a special dividend of about $2.30 per share. That special dividend would be 4% on today’s price, on top of the 5% base dividend.

All of these cash numbers would grow 5% per year. If the stock price kept up, yields would remain the same.

It is hard to beat a midcycle dividend yield of 9%, growing at 5%. But CNQ seems on track to sustain just that.

I remain content to have this stock in my portfolio. If it is not in yours, please tell me why not in the comments.

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This article was written by
High Yield Landlord

Paul brings substantial experience in research, and in understanding and developing models of uncertain systems, from his decades working as a physicist. He wrote his first Monte Carlo model aimed at investments in 2006. He has intensively researched and modeled a wide variety of portfolio options. Among other degrees, he holds a doctorate in physics and a bachelors in philosophy. His career began with running large projects for a major research laboratory, and continued with a long, and award-winning run as a professor at the University of Michigan. He has authored nearly 300 articles published in formal academic journals, and two editions of a textbook.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CNQ, EPD either through stock ownership, options, or other derivatives. 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.

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