The 40% drop in oil prices since June has wreaked havoc on the stock prices of Canadian oil producers, with many down 50% from their 2014 highs. But at turbulent times like these, it’s worth remembering: where there’s great danger, there’s also great opportunity.

Big drops in the price of oil are not unusual. In the past 10 years, we’ve seen six drops of 25% or more (including the current one), with the downturn typically lasting less than eight months.

Since the markets can’t quickly figure out how falling oil prices will affect specific companies, the stocks of oil-and-gas exploration and production companies (E&Ps) tend to fall in unison (see  “When the Going Gets Tough”).

In the current downturn, the hardest-hit of our six buy-rated E&Ps are our three oil-focused producers (not surprisingly), two of which now sport dividend yields of 10% or more. Such unusually high yields indicate the market expects to see dividend cuts, especially since about 25% of Canada’s oil production is from higher-cost tar sands.

Our take? We’ve been following our buy-rated companies for the past 10 years, through the five past downturns. They’ve weathered past price drops relatively well, and we think they’re likely to pull through this current downturn without having to cut their dividends, for these reasons:

Strong growth in production, with low operating expenses.

Solid balance sheets that act as a buffer during difficult periods.

Hedging—or selling forward—significant portions of future production. 

Why Hedging Is Key

While we think oil prices will recover from the recent lows within the next year, the pain inflicted by falling oil prices is very real. During this time, the most important thing companies can do to weather the downturn is to have in place hedging programs.

Hedging—via futures contracts, swaps, pricing collars and put and call options—allows firms to keep their cash flow high enough to maintain their dividend as well as continue investing in their operations, despite falling prices.

Oil producers that had opted not to hedge, such as the company Canadian Oil Sands, are way more likely to cut their dividends. For that company, a $10 change in the price of oil results in a CAD240 million change in cash flow. While that’s good news on the upside, it can really hurt on the way down.

But back to our portfolio holdings. Below, I describe the hedging strategies for our three recommended Canadian oil producers, as well as for our three gas producers.

Oil Producers That Hedge

Crescent Point Energy Corp. is one of Canada’s largest producers of  “light and medium” oil, which is relatively easy to refine and therefore fetches higher prices. Crescent’s shares have taken a beating lately and are down 52% from the 52-week high.

Investors are concerned because Crescent pays out about half of its earnings in dividends, the second-highest payout among our six buy-rated E&Ps. So the market is questioning Crescent’s ability to fund both capital spending and its generous dividend.

What many investors don’t realize is that Crescent Point (TSX: CPG, NYSE: CPG) has locked in oil prices of $90/barrel or higher on a large portion of its output for the next several years. For 2015, Crescent has sold forward 37% of its production at $93/barrel or higher.

More than 20% of its forecasted 2016 production is hedged above $90 per barrel. And a small amount of 2017 output (about 4%) has been sold forward at about $90 per barrel.

Crescent also has one of the strongest balance sheets among Canadian E&Ps. Because of this, and its hedging strategy, it has not had to lower its dividend during the past five downturns.

Instead of cutting spending, Crescent is currently on the lookout for acquisitions, focused on rivals with high debt.

CEO Scott Saxberg said in a recent interview with Bloomberg News, now is “a great opportunity to look for consolidation opportunities … and take advantage of guys who have weaker balance sheets.”

Crescent Point remains a buy under our reduced target of $38.

Vermilion Energy, one of Canada’s strongest E&Ps, will soon expand into the U.S. through an $11 million purchase in Wyoming’s prolific Powder River Basin. This foray into the U.S. is a sign of management’s confidence as well as the company’s ability to sustain its dividend.

Because Vermilion (TSX: VET, NYSE: VET) has relatively low debt compared with other Canadian E&P companies, it can keep expanding. It’s eyeing deals in the U.S. Rocky Mountains.

Vermilion sells forward production for the next 12 to 18 months, aiming to lock in pricing for up to 50% of output. As of November 26, the company had hedged about 20% of its 2015 production.  Vermilion has never cut its dividend; its CEO recently said that the current situation doesn’t “call for that.”

Recently yielding close to 5%, Vermilion Energy is a buy under $64.

Baytex Energy Corp. has suffered the steepest decline among our six E&P favorites, and was recently yielding an astounding 14.8%.

Part of the concern is that Baytex pays out a large percentage of its earnings as dividends, and it is more exposed to oil prices below $67/barrel.

The good news is that Baytex (TSX: BTE, NYSE: BTE) has hedged 51% of its remaining 2014 production at $96.45/barrel and 45% of its output for first-quarter 2015 at $96.54/barrel. For all of 2015, management has locked in prices of $94.66/barrel for a quarter of output.

Baytex, the most vulnerable of our holdings to falling oil prices, remains a buy under $26.

Gas Producers That Hedge

Due to the difficulty of exporting gas, the market for natural gas is much more localized than for crude oil. So gas pricing has held up well. Nonetheless, these gas producers hedge their output.

ARC Resources. A producer of mostly gas and some oil, ARC (TSX: ARX, OTC: AETUF) has hedged its oil production into 2015 and natural gas volumes through 2019.

Oil: About 45% of ARC’s crude oil and condensate output is currently hedged for the remainder of 2014 at an average price of $90 to $100 per barrel.

For the first half of 2015, ARC has hedged 6,000 barrels of oil per day at an average floor/ceiling price of $90/$101 per barrel; for this same period, it has lower-cost hedges on 4,000 barrels per day at an average price of $65.

Gas: Close to 60% of ARC’s natural gas production is hedged for the rest of 2014 at an average floor/ceiling price of $4.03/$4.17 per million British thermal units (MMBtu). From 2015 through 2019, its gas production is hedged at floor prices around $4 per MMBtu.

ARC Resources is a buy up to $28.

Enerplus Corp. Mainly a natural gas producer, Enerplus’s (TSX: ERF, NYSE: ERF) balance sheet is solid now, after management took steps to reduce debt in mid 2012, including a 50% dividend cut. The company also has a big portion of its crude oil production hedged into 2015 at prices well above the current market. These positions should provide strong cash flow into 2015. 

Oil: For output remaining in 2014, Enerplus has locked in prices of $95.29/barrel on 64% of production. For the first half of 2015, 50% of production is hedged at $93.58, and for the second half of 2015, 26% of production is hedged at $93.86.

Gas: Enerplus has downside protection on nearly 49% and 28% of net natural gas production for the remainder of 2014 and for 2015, respectively.

Enerplus remains a buy for aggressive investors under $20.

Peyto Exploration & Development Corp. Low operating costs and easy access to massive reserves reduce its sensitivity to commodity prices.

For third-quarter 2014, approximately 59% of Peyto’s (TSX: PEY, OTC: PEYUF) natural gas production was sold at a fixed price of $3.97 per thousand cubic feet (Mcf) due to hedges that were put in place over the previous 16 months. For 2015, about 40% of its production is hedged at an average price of $4.31 per Mcf.

Alberta natural gas prices are currently forecast to average $3.76 per gigajoule (GJ) in 2015.

Management expects that given these gas price forecasts, it should be able to fund its dividend and the majority of capital investment from internally generated funds.

Peyto is a buy under $38.