Oil’s dead cat bounce, or the phoenix rising from the ashes?

Most of the oil and gas market has exhibited a two-day price rally from the previous month’s carnage in what can be considered a “dead cat bounce”. This is probably in recognition that Talisman’s acquisition implies that the rest of the oil that is stuck in the ground also has similar value despite the commodity price being lower than the cost to get it above the ground.

Some companies have reduced their capital budgets already – Canadian Oil Sands, Penn West, etc., have already announced capital expenditure reductions and dividend cuts.

The question here is how low crude oil will go before it truly bottoms. In 2009, it bottomed out at US$35/barrel, while today it is at around US$55/barrel. My gut instinct here says that we are very, very, very close to the bottom, but if you recall during the era of Bear Stearns’ near-bankruptcy (technically taken over by JP Morgan), it could take a few more months for this to play out to its ultimate bottom.

One thing I do know, however, is that the demand for liquid crude is not going away – airplanes are flying, people are driving their vehicles, and trucks are delivering cargo. The need for energy in the form of transport fuels is not going away anytime soon. A commodity can trade under the marginal cost of extraction for quite some time (this was the case for Silver post-80’s collapse) but continued demand will inevitably result in price rises unless if the extractors are operating as charitable organizations – most of them are currently at US$55/barrel!

Talisman gets bailed out by Spanish firm

Everybody by now has heard that Talisman is getting bought out for US$8/share by Respol. Talisman was in the middle of some fairly serious difficulties and this is probably a very welcome takeover which should easily glide through a shareholder vote.

The focus of this post is not on the actual takeover, but rather whether the Canadian government will clear the acquisition or not – if it was a Chinese national entity doing the takeover, the primary headlines would be about whether the government would allow it or not. Presumably Talisman management would be smart enough to pre-consult with the appropriate federal officials to see if the acquisition would proceed.

This is very likely a welcome injection of about US$13 billion (when one factors in debt) and most institutions this very minute are likely dumping shares and bonds of the company – these assets will get redeployed elsewhere. Despite crude oil and gas being down a tiny bit today, most Canadian oil and gas equities have increased a moderate single-digit percentage.

The question is – are there more acquisitions to come in the Canadian oil and gas space?

General comments – furiously conducting research

I have been intensely researching the oil and gas sector, and specifically looking for companies that have decent metrics and enough fortitude to not be operationally taken down due to financial impacts of low commodity prices. I also have been trying to find collateral damage, typical cases of the baby thrown out with the proverbial bathwater.

There are many, many “hits” on my screens which makes the research very slow going. Specifically I want to know about hedging, and financial covenants and their financial structure in general in addition to the usual metrics. Dredging this stuff is very slow going.

There is a lot of high-yield out there which is trading at quite distressed levels, some of which seems very alluring. But high yield of course comes with risk.

A simple example: Do you want to lend your money to Russia for 10 years even though you are compensated with a 13% yield to maturity? I’d actually gamble that their large cap companies (NYSE: RSX is their ETF) would fare better than an investment in their sovereign debt at the moment.

Here’s a more specific example: Do you want to be a HERO? Specifically (Nasdaq: HERO) Hercules Offshore is a third-tier deepwater drilling firm, which is of a lower tier than Seadrill (Nasdaq: SDRL), Diamond Offshore (NYSE: DO), Transocean (NYSE: RIG), etc. All of the drillers have gotten killed over the past couple months simply due to the fact that nobody wants to drill into expensive ocean when you can’t even make money on the shale inland.

In HERO’s case, their equity is trading as if the company is already dead, while the bond market is placing their 2019 debt issue at a yield to maturity of about 28%. So, what is more risky: Investing in Vladimir Putin, or Hercules Offshore?

Seadrill, however, is comparable to Russia – roughly 11.5% yield to maturity on 6 year debt vs. 13% for 10-year Russian debt.

Tax loss selling candidates

The following is a table of tax-loss selling candidates for TSX-issued companies that have a market cap of at least $100 million and revenues of at least $50 million. All of these companies have lost 30% of their stock price year-to-date and one would assume active fund managers would not want to have the embarrassment of having these in their portfolios by the Canadian tax loss selling deadline of December 24, 2014.

CompanySymbolLast52wkHigh52wkLowMktCapQtrRevQtrInc
Ainsworth Lumber Co.ANS-T2.74.222.24650129.712.8
Alamos GoldAGI-T8.5913.927.75107539.3-2.2
Argonaut GoldAR-T2.296.651.9135844.82.2
Athabasca OilATH-T38.842.78123332.3-56.8
Atlantic PowerATP-T2.544.442.14297156.7-64.6
Avigilon Corp.AVO-T17.9134.513.1583475.411.6
Black Diamond GroupBDI-T20.3135.9916.6388088.49.6
Canacol EnergyCNE-T3.588.773.4440971.9-2.3
Capstone MiningCS-T2.123.351.917862220.3
Cathedral Energy ServicesCET-T3.395.232.8512158.20.3
Chesswood GroupCHW-T11.8919.4411.2812028.12.8
Essential Energy Services Ltd.ESN-T1.923.191.8624552.8-5.4
First Majestic SilverFR-T5.5613.745.2365395.68.3
Horizon North LogisticsHNL-T3.2610.052.77371123.68.1
Imperial Metals Corp.III-T9.1518.637.9269058.715.2
Ithaca EnergyIAE-T1.412.951.2947690.90.7
Kinross GoldK-T3.335.992.273605915.644.1
Labrador Iron Ore RoyaltyLIF-T18.2134.8717.7511835235.9
Legacy Oil + GasLEG-T3.9510.033.9716169.318.8
Lightstream ResourcesLTS-T3.59.092.28750314.83.9
Long Run ExplorationLRE-T2.856.092.7432156.820.8
Pengrowth EnergyPGF-T4.487.784.172343476.952.2
Penn West PetroleumPWT-T5.05114.542527719143
Points InternationalPTS-T14.935.514.5923276.81.3
Redknee SolutionsRKN-T3.827.823.1543670.7-7.5
Savanna Energy ServicesSVY-T5.269.315.2474201.1-24.4
Serinus Energy Inc.SEN-T2.034.881.416041.98.7
Sirius XM Canada HoldingsXSR-T5.210.55.0168877.34.4
SMART TechnologiesSMA-T1.485.91.41176142.712.1
TAG Oil LtdTAO-T1.83.641.4712115.44.1
Talisman EnergyTLM-T6.5313.136.0169761742.3462.5
Teck ResourcesTCK.B-T19.229.116.8710969225184
Transat A.T.TRZ.B-T8.6614.77.65340943.525.8
TransGlobe EnergyTGL-T4.17104.18322155.526.2
Trilogy Energy Corp.TET-T13.5932.312.231724171.128.2
Trinidad DrillingTDG-T6.3212.896.07900170.6-24.8
Twin Butte EnergyTBE-T1.422.51.35499152.67.2
Westport InnovationsWPT-T6.1224.115.9739633.4-27.7
Yamana Gold Inc.YRI-T4.7211.863.934043516.5-1023.3

Some obvious conclusions:
– Gold and energy are not liked.
– Energy service companies are also not liked.
– Was a little surprised at Transat considering Air Canada and Westjet’s relative performance.

Oil and gas

As readers may suspect, I have been intensively looking at the oil and gas producer market directly as a response to the rapid decrease in world oil commodity prices over the past three months.

I don’t know whether oil is going up or down from here, but from the US$75 perch it is at today, I would suspect it is more likely than not we will see a US$100 (+33%) WTIC barrel price rather than US$50 (-33%).

I decided to restrict my choices to strictly oil and gas producers that are within the confines of Canada. I have a fairly solid grasp of the regulatory and legal side of what Canadian producers face and also a good feel for the political climate that may drive economic changes within the various firms (e.g. provincial governments deciding to tinker with royalty rates).

Go take a look at Transglobe (TGL.TO) if you believe you have any idea what the political-economic stability of Egypt is. If you think they will be all right, then you’ll stand to make a small fortune.

In the Canadian world, crude oil trades at a discount to the prevailing WTIC price for a variety of reasons. Heavy oil producers have an even higher penalty on pricing. The differential is unlikely to change soon and this has generally been the focus of the Canadian government to address the differential (via pipelines, and opening up an export route to east Asia via BC which is not likely to happen anytime soon). The discount that Canadian crude has over the prevailing North American price is a significant economic issue for those that derive their living from Canadian energy, but it is such a political issue that I will stop talking about it here. What is financially relevant, however, is the market is very well aware of this and is not pricing in any anticipation of the Canadian pricing disadvantage stopping anytime soon.

I will give an example. If a surprise deal is reached with the relevant First Nations bands in British Columbia and the Northern Gateway project is commenced, you would see a huge spike in Canadian oil and gas producers for sure.

After doing a ridiculous amount of exhaustive analysis, I realize that from my third party perspective it is going to be very difficult to pick alpha from companies that have very cookie-cutter characteristics and that indexing is the better way to go. Unfortunately most Canadian indicies and ETFs (e.g. XEG.TO) involve a huge concentration of Suncor, CNQ, Cenovus, Crescent Point, EnCana, Husky, etc., and while I think these are fine companies that will likely survive to the point when I start collecting Old Age Security, they do not offer the most potential for appreciation. So instead of going for an index ETF, I decided to just create my own mini-ETF with a few positions. I have taken a position in three companies with average sized positions. I had intended to do four but one of the names has since climbed higher than what I was willing to pay for it.

I’ve decided on creating a mini-index for myself consisting of PWT.TO, PGF.TO and DTX.TO. The first two should be well known to most people. They have been around since the former income trust glory days and are income-oriented investments. Despite the fact that they have massively huge yields (which had nothing to do with the investment decision at all), I generally believe PWT’s new management is on the right track (reduce debt, focus on costs, be up-front with shareholders when your previous CFO was over-aggressively capitalizing expenses, etc.). PWT is unhedged.

PGF has an heavy oil project that is being heavily discounted by the market simply because they are throwing so much more cash out presently than they are taking in, but they will receive a huge benefit from such expenditures from 2015 onwards in a Cenovus-like manner and then they will be able to get their debt metrics in order. They have hedged roughly 2/3rds of their 2015 production at ~US$84 and from there they will appropriately try to game the commodity market.

DTX, whether through luck or purposeful selection, appears to be a very heavily profitable producer. They don’t give out a dividend because they want to grow (which is exactly what they should be doing given their reinvestment returns). They’ve hedged about 1/6th of their production in 2015 at around US$88-ish (good market timing!).

There’s more to the above stories but I will leave it at that.

The price depreciation over the past half year in all of these issues has led to a margin of error factor that appears to present a good risk-reward ratio.

The last name that I wanted to include on the list was something heavy in gas rather than oil, and that was Birchcliff (BIR.TO). Unfortunately in their case, after I did my due diligence on them a couple weeks later than I should have and I was looking at a stock price that I thought I could time the market better than what actually happened (take a look at their last month of trading and you will see why). If they sink again to the single digits, I will likely be taking a position in them.

I wish a company like Peyto would crash down 50% but clearly this isn’t going to happen.

All of these companies have a possibility of being taken over by larger producers. They also all have insider purchases, which was a partial consideration in my sweep of companies.

I want to thank Neil J who offered some interesting comments on a previous post of mine. There is no way I would have reviewed DTX if it wasn’t for his comments. I very rarely pick off names that are brought to my attention in this fashion, but this was a rare, rare exception.

Given my relative uncertainty in underlying commodity prices (I am not a fan of commodities in general at this point in time, but I am making a very special exception for energy), I do not anticipate taking more than a total 20% position combined in oil and gas producers and related firms, but this is probably more weighing I’ve had in the sector for quite some time. I am comfortable holding this until we start seeing stories of peak oil and this sort of stuff again.

Genworth MI valuation follow-up

Genworth MI is up about 4% following their quarterly report.

Book value (including intangibles) is $34.76/share diluted, while excluding intangibles is about $34.57/share diluted (there is not a lot of baggage on the balance sheet other than deferred policy acquisition costs that gets expensed off when revenue is recognized).

Taking the tangible book value and giving a standard 20% premium over book yields about $41.48/share, which is slightly below what it is trading at present ($41.70 as I write this). There is nothing exceptional in the portfolio that would warrant an extraordinary value beyond a percentage multiple over book (unlike companies like Berkshire and Fairfax which require some careful consideration with their own portfolios).

From a perspective of price-to-book for typical insurance companies, MIC has reached its full valuation and any gains to be made from here are likely to result from minting cash through operations rather than any huge expansion of the price-to-book multiple. This statement could be incorrect as market psychology usually likes to take things to excess and also the market is still yield-hungry. MIC does deliver 3.74% at current price with a historically rising dividend which would appeal to fund managers.

Income-wise, they are still at around the P/E 10 level which also has some valuation appeal for those that invest on that basis.

I would not feel too badly about lightening up my holdings at current prices, which I might do depending on other available options.

It is unfortunate that I would only get interested once again in this company if there was a true housing crisis in Canada. Otherwise it is unlikely the market would offer a huge discount to book that was initially given back in 2012 – where the equity was trading at over a 1/3rd discount to book along with many other insurers. These inefficiencies have been mostly corrected by the marketplace and the companies that are left with discounts to book have genuine issues that result in such valuations.

Looking over my previous work on MIC, I have done a relatively good job of analyzing the firm and it has been an amazing gainer for me over the past couple years. I wish I had candidates on my list that have nearly the risk/reward ratio that this one did.

Genworth MI Q3-2014 results

My previous projection on Genworth MI’s (TSX: MIC) Q3-2014 was mostly in-line.

Specifically, I projected a dividend increase (which was done – from 35 cents to 39 cents), and a likely chance for a special dividend (which will be 43 cents this quarter). Operating EPS was slightly less than I expected (95 cents diluted vs. “around $1″ expected) and this was primarily due to the larger loss ratio.

A few notables:

1. They wrote $217 million in premiums this quarter, which indicated a very high volume market for mortgage insurable Canadian real estate. Year-to-year, about $20 million of the $56 million increase was due to the premium increase announced by CMHC earlier in the year. The rest of it is sheer volume, mostly in the high loan-to-value business (i.e. highly leveraged loans).

2. Loss ratio was 21%, slightly higher than I was expecting but still quite low by historical standards. The MD&A projects “35-40% over an economic cycle” and for those of you that are mathematically astute, this implies that there will likely be times where the loss ratio will be at the 60-70% range (and the common stock would be quite battered at this rate was it would show the entity as barely making any money and shelling out huge amounts for mortgage claims).

3. Delinquency rates are still quite low although they went ever so slightly up from quarter to quarter, interestingly enough in the low loan to value category. I believe this is just white noise.

4. OSFI regulations regarding minimum capital for mortgage insurers has more or less been finalized and using 2015 standards, has the company at a 223% position in terms of minimum capital required – the company’s internal target to survive a prolonged recession is 220%. This excess capital is presumably given off in a special dividend.

All-in-all, the company is continuing to mint cash and shareholders should be extremely happy. The downside to this is that I can’t really see how things can get any better for the company. Maybe if CMHC pulled out of the mortgage insurance market, but there is no way the federal government will allow this cash cow to stop generating money for the federal coffers.

At current valuations (CAD$40/share) I cannot recommend a purchase. It is on the upper end, but not quite exceeding, my fair value range for the company. This has been a big winner for me over the past couple years and it will be sad to see it leaving the portfolio, but superior gains are only to be made when there is blood on the street. A couple years ago, the blood was projected to be in Canadian real estate. Right now it is elsewhere.

For those with nerves of steel – buy oil

Most investors are likely aware that the price of oil has plummeted. This has taken a lot of equities down with it.

This is a very rough statement (some areas are cheaper to mine than others), but it is getting to the point (roughly US$75-ish) where a lot of tight oil (shale) is unprofitable to mine. This is where most of the oil boom from North America has originated. Heavy oil (oil sands) highly depends on where it is mined.

There are geopolitical games being played by OPEC and Saudi Arabia and the rest of the world. Commodities can trade under the marginal cost of extraction for awhile, but not indefinitely – especially in the case of crude oil, there will be demand.

The question is who shuts off the supply first? It will be the most insolvent high-cost producers, and then increasingly the more solvent unprofitable producers until the market supply decreases. Only then will we see oil prices turn around.

I do not believe a downturn in the oil commodity price will be sustainable for a long period of time in light of global demand still being high.

Decreasing capital budgets for 2015 will translate into decreased supply. However, this is not a speedy process. Most tight oil producers require a continual stream of capital to keep production levels stable and so I would guess some time in 2015 you are going to see a very sharp rebound in oil prices once enough supply has been shut off.

There is a cliche that markets go up slowly but crash quickly. With commodities, they go down slowly and rise quickly.

From my 50,000 foot perspective, there seems to be opportunity. I’m going to guess that low prices will persist until the end of this year. I do not see low prices continuing throughout 2015 unless if there is some sort of major global slowdown beyond what we already see in Europe and China (in the latter case, if you can call a decrease from 7% GDP growth to 5% GDP growth a “slowdown” when your GDP is already 9 trillion dollars, then it is a very odd definition of a slowdown!).

Picture yourself as some economic analyst in the People’s Republic of China with a mandate of securing global energy supplies. Right now you’d be licking your lips and looking at the various publicly traded entities out there. Your only fear is having governments refusing takeover offers out of national security concerns.

Broad energy ETFs (which also include refiners) that encompass this category are XLF, and VDE, but the exporation and producer index (XOP) has been significantly more impacted. XOP has an MER of 0.35%. The Canadian equivalent (and this ETF would provide eligible dividends as it would be from Canadian and not American sources) is XEG.TO and this ETF contains the usual list of Canadian energy producers (Suncor, CNQ, etc.) for an MER of 0.6%.

If you’re brave and have nerves of steel, buy oil. I can’t tell whether right now or the next three months or so will provide the lowest price point, but from a historical perspective, it is closer to the bottom than it was a month ago!

Reviewing underperforming Canadian oil and gas producers

One observation: It is abundantly clear that oil and gas producers in North America are going to be trimming their 2015 capital budgets. This will disproportionately affect the service companies, but most of this has already been baked into equity prices.

I have no idea where oil prices will be going in the short term. There is plenty of incentive for those that have already sunk a boatload of costs into their wells to keep them flowing. In the short term you might see some price shocks, but in the medium and long term, I cannot see oil losing too much demand relative to supply levels. While getting into my vehicle and experiencing heavy traffic is hardly a statistical sample that you can extrapolate across the world, intuitively I do not think electrification of transportation is going to be an imminent threat on crude oil (or natural gas) as being the transport fuel of choice. Nor do I see the requirements for plastics or any derivative products of crude being replaced anytime soon.

The point of the preceding paragraph is that crude oil is not going to disappear off the map anytime soon (unlike its predecessor, which was whale oil).

With my very generalized valuation theory on oil and gas producers that “oil prices are a reasonable proxy for company performance plus financial leverage effects”, I note that WTIC (West Texas Intermediate Crude) reached the US$80/barrel level back in June of 2012:

wtic

A very simple theory is that oil and gas producers that are trading below what they were trading in June of 2012 should be given a second look to see what caused their relative dis-valuation from present oil levels. A surprisingly large number of Canadian oil and gas companies are trading well above their June 2012 levels despite the oil price difference.

One reason is simply due to good (or lucky timing!) hedging strategies.

Another is due to the mix of oil (and the different types of oil), transport issues, and the percentage of natural gas and natural gas liquids in the revenue mix of a company – in general, while you aren’t suffering pure hell at US$2.50/GJ back in June 2012, your typical gas driller hasn’t been wildly profitable compared to the good ol’ days back in 2008 when you were at US$10.

There’s also the simple reason of having excessive financial leverage and not being able to finance the corporation at revenues obtained at current prices.

There’s plenty of reasons why an oil and gas company would be trading lower today than in even worse price environments seen in June 2012.

So given everything trading on the TSX, I’ve done some homework as a starting point and gone through the companies with the following criteria:
– Share price over CAD$2
– Market cap over $1 billion
– Not a foreign entity (although they can have foreign operations).
– Trading lower today than they generally were in June 2012.

We have, in descending order of market cap:

CVE.TO
TLM.TO (not that they’ve been having difficulties lately!)
BTE.TO
PWT.TO
PGF.TO
TET.TO
BNP.TO
LTS.TO (I was a prolific writer that commented on its ridiculously high valuation when it was known as Petrobakken).

I note that Canadian Oil Sands (COS.TO) is trading barely above what it was in June 2012. This is probably the most purest equity play on WTIC possible beyond putting money in USO (not advisable).

Any thoughts? Comments appreciated.

Market volatility

Look at the last couple weeks of trading on the S&P 500:

spx

This is a panic down-panic up type chart – especially over the past few days, it resembles a short squeeze more than anything else.

The overall trend in the S&P 500 over the past couple years has been nearly a straight-line up chart:

spx-2

Is this going to continue?

Normally in the prior market dips you get this “slowly climb the wall of worry” effect, but this time it appears to be different.

Implied volatility continues to be strongly anti-correlated to market price, but is now settling back into the teens again. Will there be another violent outburst?

vix

And finally, 10-year bond yields are still trading below what they were when this whole market calamity started:

tnx

I’d be careful. My guess is that we’re going to see some stormy seas over the next couple months. Whatever started this is not likely finished yet.