Canadian oil driller Vermilion Energy (NYSE:VET) offers investors a yield of more than 9% with a monthly payment schedule. That's enough to get the ears of most dividend investors to perk up. Now add that the energy company is globally diversified and growing its production, and Vermilion starts to sound like a pretty enticing investment. And in some ways it is, but you need to go in with your eyes open to the risks. Here's what you need to know before you buy Vermilion.

The good stuff first

Vermilion's business is broken down into three main parts: North America (62% of production and 52% of funds from operations), Europe (33% and 39%), and Australia (5% and 9%). It specifically focuses on more conventional oil plays with longer reserve lives and slower decline rates, which is very different from the fast-growing unconventional onshore U.S. energy sector, where shorter lives and quicker decline rates are the norm.   

Two men writing in notebooks with an oil well in the background

Image source: Getty Images

The company is projecting 19% production growth in 2019 based on capital spending plans of roughly $530 million. Looked at on a per share basis, which takes into account the issuance of stock to fund the business, production growth in 2019 is projected to be roughly 8%. That growth has been helped along by two acquisitions in 2018, one in Canada and another in the United States, and continues the growth trend that's been in place since 2013. 

In the first quarter of 2019 FFO per share increased 27% year over year, largely driven by increased production. Sequentially from the fourth quarter of 2018, FFO per share grew by 14%, helped along by a mixture of increased production and higher oil prices. And, after a long stretch of stable dividends following the deep oil decline in mid-2014, Vermilion upped its dividend again in 2018. So far, so good. 

Some less desirable news

There's no question that oil companies are a little out of favor today, so it isn't surprising that Vermilion has a high yield. However, the 9%-plus yield is at the high end of the spectrum. And there are some pretty good reasons for this. For starters, the dividend cost nearly $100 million in the first quarter, which was roughly half of the $200 million in cash flow provided by operating activities. That's great until you add in the $230 million in capital expenditures the company made in the first quarter. To put it simply, cash flows didn't cover the dividend and capital spending in the first quarter. 

That's just one quarter, and based on the full-year capital spending projection of $530 million, the rest of the year should see lower spending. If you use the first quarter as a run rate, the company will generate around $800 million in cash flow and pay about $400 million in dividends, leaving just $400 million for capital spending plans of $530 million. There are any number of ways that the shortfall here can be covered: Tapping the capital markets with debt and equity sales, using revolving credit lines, or an oil price increase (which is impossible to predict) could save the day. 

The main point here is that dividend coverage is tight. Investors are avoiding the company because there is a very real risk that the dividend could be cut in order to support its capital investment plans. That's not something the company has done in the past, with a long history of tight coverage on the dividend front. But that history doesn't mean a deep oil price decline wouldn't force the board's hand this time.

Vermilion, meanwhile, is saying that that $40 per barrel oil would allow it to cover sustaining capital expenditures and the dividend, with a little left over for growth spending. Management says it can cover all its spending plans with oil in the $55 per barrel. However, based on a closer look at the company's cash flow statement, those estimates seem, perhaps, generous. No wonder investors are a little leery. 

Complicating all this is Vermilion's leverage. Long-term debt makes up roughly 40% of the company's capital structure. While not an outlandish figure, it is toward the high end of the industry. Cash on the balance sheet, meanwhile, is roughly $5 million, which isn't much of a cushion. Vermilion covered its trailing 12-month interest costs, also known as times interest earned, by a comfortable six times in the first quarter, but volatile energy prices could quickly shrink that number.

VET Total Long Term Debt (Quarterly) Chart

VET total long-term debt (quarterly) data by YCharts

In other words, adding more debt isn't a great plan. And with a 9%-plus yield, selling shares would be expensive, which leaves Vermilion in something of a quandary about continuing to fund its growth plans if oil prices drop below $55 per barrel. And that, rightly, has investors worried about the dividend. That's not to suggest it wouldn't be able to sustain the payout. It has been making use of its revolving credit facility to help fund spending. But there is a real risk that low oil prices could, if sustained over a long enough period of time, wipe out Vermilion's dividend. In fact, with oil now trading in the $50 to $60 per barrel area today, it wouldn't take much of a price drop to materially increase that risk.

Eyes wide open

If you buy Vermilion and its hefty yield, you are making a bet. If oil prices stay above the $55 per barrel range, you win and the dividend is well covered. If oil prices dip below that level for a sustained period, then you have to worry about the sustainability of the dividend. Oil is a volatile commodity prone to swift and dramatic price changes. If you believe oil prices are heading higher over the long term, then Vermilion is an interesting, high-yield way to play the space. If you have a moderate to conservative investing profile, however, you'd probably be better off with a lower-risk option like ExxonMobil or Chevron.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.