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Top Dividend Stocks to Play High Oil Prices

March 22, 2012 – by Richard Band

What’s an investor’s biggest long-term enemy?

Not depression or economic collapse. Not even taxes. It’s the insidious debasement of the dollar through inflation. (You’ll need $7 to buy today what a dollar would have bought in 1965.) If you’re retired or otherwise living off your investments, one of your primary goals for the long run is to protect your purchasing power.

Certain tangible assets, such as gold and silver, can serve this purpose admirably — at least if you hold them long enough. However, precious metals and other raw materials present a difficulty: They generate no income. You have to sell them to realize spendable cash, and there’s no guarantee the market will offer you a favorable price if you need to sell in a hurry.

To sidestep these obstacles, I advise folks in or near retirement — or those who simply want to build more income (and stability) into their portfolio — to invest a portion of their wealth in companies that produce commodities. At the moment, the oil and gas sector in particular is brimming with opportunities to earn a generous cash yield up front.

Of course, the petroleum-producing business also furnishes an excellent long-term hedge against inflation. As the chart below illustrates, oil usage in the Old World (United States, Western Europe, Japan) actually has declined a bit since the late 1990s. But the New World — Asia, Latin America and so on — has taken up all the slack and more. In real (inflation-adjusted) terms, we can expect oil prices to remain high for a long time to come, triggering outsized profits for companies that mine “black gold.”

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2 Dividend Stocks to Play Oil Producers

For conservative investors — a category that includes most retirees — I suggest taking a look at giant, well-known international producers. Some are on the expensive side right now, such as ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX). Thus, I rate this pair a hold rather than a buy at the current price. Ditto for BP (NYSE:BP). On the other hand, here are two oil majors you can safely buy for income and growth at, or slightly below, today’s levels:

My top pick right now in the group is Royal Dutch Shell (NYSE:RDS.B), which currently yields 4.6%. In February, Shell raised its dividend for the first time since 2009 — a sign of management’s growing confidence that the company can meet its target for a 25% boost in production by 2017-18. I favor the Class B shares, based in London, because they incur no dividend withholding tax. Buy RDS.B at $73 or less.

My second pick is Total (NYSE:TOT). Frequently overlooked by U.S. investors, this French outfit boasts many attractions, starting with a secure 5.4% dividend. I’m also pleased that TOT in 2011 replaced 200% of the reserves of oil and gas that the company lifted out of the ground. A high reserve-replacement ratio suggests that TOT’s production will increase faster than the industry average in the years ahead. Buy TOT at $55 or less.

Both companies pay quarterly dividends. Note that France imposes a 25% withholding tax on dividends. You can obtain a credit for this tax on your U.S. Form 1040, but only if you hold TOT in a taxable account (not a retirement account).

2 High-Yield Canadian Dividend Stocks

For a smaller, more-aggressive piece of your portfolio, I recommend dipping into a few high-yielding Canadian energy producers. Before 2011, our northern neighbor allowed “income trusts” to avoid corporate tax by passing along the lion’s share of their earnings as dividends to shareholders. That law has lapsed, so the trusts have now converted to corporate form and are paying taxes. Most — though especially the producers oriented to oil (rather than natural gas) — still are dishing out juicy dividends.

My top pick is Enerplus Corp. (NYSE:ERF). About 85% of ERF’s cash flow comes from oil, and the company is growing its oil output with new volume from the Bakken Shale in North Dakota. At first blush, ERF’s towering 9.1% yield would seem to indicate extraordinary risk. However, Enerplus maintains a strong balance sheet, with less debt than most of its peers. Furthermore, this tough little operator doles out only 57% of its cash flow (EBITDA) in the form of dividends. Hence, I’m convinced that — barring a steep drop in oil prices — ERF will maintain its payout at the present rate. Buy ERF at $25 or less.

My second pick is Canadian Oil Sands Ltd. (PINK:COSWF), a leading producer of synthetic crude from the bitumen sands of Alberta. Once COSWF wraps up an ambitious expansion program in 2013, the dividend will likely soar, to perhaps C$2 per share or more by 2015. Bear in mind, though, that turning tar into syncrude is a costly process, making COSWF’s results highly sensitive to oil prices. Furthermore, bottlenecks in the pipeline system that transports crude from Canada into the United States can widen short-term swings in the prices COSWF receives for its oil. Only investors (like me) with a rubber soul should own the stock. COSWF pays a quarterly dividend and is currently yielding 5.5%. Buy shares at $24 or less.

Note that Canada collects a 15% withholding tax on dividends paid to U.S. residents. However, you might be able to avoid the tax in a retirement account, so check with your IRA custodian.