ARC Resources recently released its Q2 numbers reporting strong operational results. Relative to 2011, quarterly volumes rose 14% year over year for Q2 with oil and natural gas liquids production up 19%.   On the other hand, the company’s funds flow dropped 60% during the same period. But despite the drop in cash flow, management believes the dividend is sustainable as a cut would be the last measure to consider if a prolonged period of low commodity prices is experienced. Let’s take a closer look at the company.

ARX’s netbacks were pounded by record low natural gas prices this year realizing $2.03/mcf (before hedging) versus $4.05/mcf a year earlier.  The company averaged ~94,500 boepd with oil & liquids volumes accounting for 38% of production and 80% of revenue. YTD average production is ahead of its guidance of 91,000-94,000 boepd for the year thanks in part to incremental volumes resulting from the first full quarter of operations from ARC’s newest gas plant at Ante Creek.

There’s a good reason ARC is raising up to $345 million by selling shares, the dividend is currently not covered by cash flow and the company needs to ensure they can afford to spend a hefty capex of $800 million next year which includes building 2 new 60 million cubic feet per day gas plants in BC. The latest issue is opportunistic given its share price has recovered sharply following PRQ’s takeover by Petronas and preserves its financial strength leaving it with more than $550M to draw on. Let’s take a look at the dividend sustainability ratio:

2012 scenario + price deck:

• Average production: 94,500 boepd (38% liquids)
• Edmonton Par oil price: $83 CAD
• AECO Natural gas: $2.90 /mcf

The price for oil represents the average price realized YTD by the company; it is relatively conservative as it accounts for the risk of volatile differentials between Edmonton Par and WTI prices. Any improvement in Europe or the global economy would certainly contribute to realizing a higher price for oil. The realized price of natural gas is significantly higher than the average YTD price of $2.10/mcf and that’s because the company has 60% of its NG production hedged around $3.25/mcf.  Based on the above, my calculations produce a CF netback (profit per barrel) estimate this year of ~$20 per boepd which results in a total payout ratio of about 135% excluding drip.

That’s a deficit of ~$250 million dollars for 2012!

But if we take DRIP proceeds into account, with a ~30% participation level the company recovers $110M which brings the total payout ratio down to ~120%.  That’s still a deficit of $140M for this year which can be absorbed through the current credit facilities.

According to management, a dividend cut would be the last measure following deferred capital spending. The active hedging strategy certainly helps mitigate commodity price volatility, the company hedges up to 55% of production 2 years out and a maximum of 25% beyond 2 years. Furthermore, the latest equity issue also improves its financial position keeping debt to CF at 1.4x.  Realized natural gas prices will also help since the forward strip is considerably higher in 2013 (>$3/mcf) and thanks to hedges.

I believe ARC’s dividend is safe and the company will survive this challenging commodity environment and move on to prosper in 2014 and beyond. The commodity that has inflicted so much pain on its CF this year will provide ALL the upside once export facilities become operational through its significant Montney natural gas and liquids resource plays in BC and Alberta.

ARC is the third largest operator in the region with over 400 net sections of land. Just in NE BC, the Montney holds a best estimate of 4.0 TCF and 98MM boe of liquids in contingent resources (quantities estimated to be RECOVERABLE).

Finally, ARC ARX.TO 30.76 [+0.65] isn’t cheap at this price level, the yield at 5.1% pretty much proves it. But it is a well-run company and while it still carries the risk of high exposure to natural gas, it’s quality acreage makes it a take over candidate a la Progress.  Excluding a take over scenario, at the current price level, I don’t think this is the hottest stock to hold for capital gains in the short term. The company is currently focused on its oil and liquids rich opportunities and remains a long term call on natural gas paying a dividend to those who have the patience to wait.

 What do you think of ARC?

Not long ago, I was looking at my investment options for 2011 as I plan to contribute to my RRSP account early next year. GICs were the first to be removed from the list because of the dismal rates that were offered. With a 5 year GIC paying a meager 2.75% at best, Canadians who expect to reach their dream retirement will be moving past it as well. After all, the perfect retirement we are constantly bombarded with on TV by our financial institutions will just not be possible with such low rates of return.

In 2011, those who are brave enough to get back into the stock market after the beating they got in 2008 and those who decided to refocus on yield because they got sick of losing to inflation and getting punished for saving will certainly not be looking for the highest risks out there. They are risk averse, yet they are looking for something that pays more than a GIC or a High Savings Account; they are yield hungry. Where will the average person be injecting his money next year to get a decent yield without carrying excessive risk?

The interest rate variable

The decisive variable that will be directing the flow of money into the market in 2011 will be the interest rate, and for us Canadians, we will have to look to our southern neighbor for guidance. When it comes to forecasting, everyone stands on the same ground. Neither the number of titles you hold nor their length will give you any edge in this art since no one knows what’s coming next. Having said that, allow me to share my prediction for 2011.

Just last week, the bank of Canada left the benchmark interest rate at 1% citing increased threats to the global recovery. Between European sovereign debt issues, a stubborn unemployment in the US and slowing growth in key emerging markets, the central bank does not have much of a choice really. The risk remains on the downside; the Bank of Canada cannot afford to increase the gap between Canadian and US rates. The Canadian dollar is close to overtaking the US dollar. Further appreciation will certainly jeopardize whatever manufacturing jobs we have left and strain our exports further. Since QE2 has just launched, the US economy will take its time to stabilize in 2011 and return to growth mode slowly. The Federal Reserve will not be capable of raising rates any time soon in the US. Based on all of the above, I do not expect any significant interest rate hikes in 2011 by our central bank. If any, it will be small and well into 2011.

Canadian Stock Market: 3 Sectors that could benefit

You can still find decent yields out there if you look for high quality dividend paying stocks not to forget the potential for capital gains. Here are 3 sectors that I expect will be attracting money in 2011 by order of risk:

Low Risk

Canadian Banks: The Canadian banking sector survived the liquidity crunch in 2008, so chances are it will survive a volatile 2011 while the recovery is trying to gain traction. Investors can count on yields between 3.00% and 4.50%.

Medium Risk

Canadian REITS: Real Estate Investment Trusts have been a top performer in 2010. I believe there is still room for growth in 2011 as many of these REITs still have attractive yields reaching 8% in some cases. For those who prefer ETFs, the iShares S&P/TSX Capped REIT (TSE:XRE) currently yields 5.7%.

Above-average Risk

Energy Corporations: Oil prices have hit $90 a barrel recently. In 2011, analysts expect oil prices to remain strong backed by growing demand from the developing world. Many income trusts recently converted to corporations in the energy sector and kept generous monthly distributions. Take Crescent Point (TSE:CPG) for example, it is a heavy weight light oil focused Canadian producer which currently yields 6.4%.

Final Thoughts

I mentioned only 3 sectors above that could be attracting a lot of money as we transition into 2011. There are other sectors that stand to benefit as well such as Utilities and Pipelines. I chose to ignore precious metals as the level of risk is higher and because the sector is lacking in dividends. As for me, I will definitely be positioned into light oil in 2011 as I expect prices to remain strong well into the year unless we hit a second recession.