Stress in Canadian oil and gas

I wrote earlier this year about the downward slopes of Canadian energy companies and six months later, nothing appears to have changed – the trajectory for most of these companies continues to go down.

Commodity pricing is also highly unfavourable – WTIC crude is at US$43/barrel as I write this and the CAD/USD exchange is around 75 cents on the dollar.

So at these price levels, there are going to be plenty of companies that will find it very difficult to make any money.

What hit my radar today is Cenovus (TSX: CVE) taking a hit after their investor day presentation – their CEO is calling it quits at the end of October and planning a $4-5 billion asset disposal. The stock is down to about CAD$9.20/share – noting they raised $3 billion in capital back in April at CAD$16/share when they purchased back their 50% of their partnership in the Foster Creek/Christina Lake projects. Those shareholders must be feeling pretty “steamed” right now, having experienced a 42% depreciation on their capital in a few months.

In their presentation, they stated that the company is break-even at US$41/barrel. You can be sure that if present pricing stays at the current levels, there are going to be a lot more medium-cost producers that are going to start feeling the pinch on their balance sheets – the “bunker down and wait for better pricing” strategy only works when your rivals are out of money and you’re sitting on a treasure chest. Right now, everybody has enough liquidity to last another year or so before things really start hitting the fan.

Equity holders, in addition to feeling already light-pocketed, should continue to worry as debts rise and creditors start taking more and more of any available cash flows out of these corporations.

And as readers know, when there is desperation in the financial markets, that’s usually a good time to invest money. But now still doesn’t feel like the right time.

State of the Canadian Debenture Market

I find the Financial Post’s compilation of Canadian exchange-traded debentures to be a very handy list to refer to. It is not comprehensive (there are a few issuers here and there missing) but for the most part is a full snapshot of the market environment.

Looking at the list, I think it is a very good time for Canadian companies of questionable credit quality to be issuing debt. Most of the debt on this list is trading at yields that do not properly represent (my own evaluation of) their risk.

Accordingly my research time is increasingly on the equity side of things in the non-indexed space. A great example of my readings included the Kinder Morgan Canada prospectus, worthy of a future post!

With regards to the debentures, I’ve sorted the debt by yield to maturity and decided to arbitrarily cut things off at 8%:

IssuerSymbolCouponMaturityYTMPithy Notes
Discovery AirDA.DB.A8.38%30-Jun-18118.28%Way behind secured debt, no control
Lanesbourough REITLRT.DB.G5.00%30-Jun-2259.10%Insolvent
Gran Columbia Gold CorpGCM.DB.U1.00%11-Aug-1843.99%81% mandatory equity conversion
Primero MiningP.DB.V5.75%28-Feb-2021.85%Operational mess, solvency issues
Argex Mining Inc.RGX.DB8.00%30-Sep-1919.07%Illiquid, no revenues!
Toscana EnergyTEI.DB6.75%30-Jun-1817.27%Senior Debt to cash flow is high
Gran Columbia Gold CorpGCM.DB.V6.00%02-Jan-2015.14%I own this
Westernone EquityWEQ.DB6.25%30-Jun-2013.94%Likely equity conversion June 30, 2018
Entrec Corp.ENT.DB8.50%30-Jun-2113.02%Cash flow negative, senior debt high
Temple HotelsTPH.DB.D7.75%30-Jun-1711.78%One month to maturity
Difference CapitalDCF.DB8.00%31-Jul-189.56%Payback not certain
Temple HotelsTPH.DB.E7.25%30-Sep-179.47%4 months to maturity
Fortress PaperFTP.DB.A7.00%31-Dec-199.22%Never figured them out
Temple HotelsTPH.DB.F7.00%31-Mar-188.11%How much $ does Morguard have?

I really don’t see anything worth locking capital into in this table at present prices. I do own one of these convertible debentures, but it is at a price where I would not buy (or sell) – my purchase price is from much lower prices and it is the only debt on this list that gives a warm and fuzzy “secured by all assets and nobody can step in front of me” arrangement.

I also note that the table is missing Yellow Media and Grenville Royalty which are both trading at 9% and 16%, respectively, but they are both unattractive for various reasons.

High Frequency Trading Gone Nuts

Attached was a rather amusing ticker-tape of the bid/ask in a particular stock that I track:

So the algorithm is to raise the asking price a random and rising value from roughly 14-16 cents a share, increasing range, each and every second.

Just imagine if you were the programmer doing this and accidentally got the code mixed up so you were doing the OPPOSITE. Good programming has many layers of fail-safes to prevent this malicious code from ever breaking through, but once in awhile these result in flash crashes. Knight Capital on August 1, 2012 was another famous example (blowing up their own firm on a single trading day).

If you are the counter-party on these incidents you have to react very quickly to take advantage of errant trading. It is rare when this happens. Mistakes like this also affect illiquid products much more.

Stormy seas

When politics is attributed as the reason why the broad market drops by 2% in a day, you know there is more to come (the reason is most certainly not politics).

Brace yourselves – I’ve been continuing to liquidate things and are well positioned for a market crash.

(Update, June 4, 2017: S&P 500 is up 4% since I wrote this, in a huge upward trajectory! Shows you what I know about short-term market timing!)

Avoided another time bomb – Aimia

Aimia (specifically their preferred shares) were suggested to me a year ago as a reasonable risk/reward and a relatively high yield.

I declined. Today is the reason that I saw would likely happen.

Air Canada will be ending their business with them in 2020.

Everything in their capital structure is trading massively down – common shares are down over 50%, and preferred shares are down about 30%.

Good market timers could have bought when the margin calls were starting to flood in at around 10:00am Eastern time. The preferred shares at one point in time were down even more than the common shares.

(Update, I have included the chart of AIM.PR.A for illustration below)

I have no idea what the business prospects of Aimia is (although this news about Air Canada is VERY negative) and thus I will still not touch them.

I will, however, be a little more diligent at liquidating the meager amount of Aeroplan points I still have remaining – companies like Aimia can decrease deferred revenue liabilities by simply increasing the cost of “rewards” that their customers have already pre-paid for (can you tell what I don’t like about their business?).

Another Canadian Finance website of quality

Reminiscences of a Stockblogger (I don’t know his real name) has an excellent post on identifying what makes your edge in the marketplace. His performance has been excellent and his following paragraph resonates with me:

I think I have put up enough years of out-performance to tentatively conclude I have some sort of edge. Its still possible that I don’t; maybe I will blow up yet and these past years will prove to be a statistical aberration. But as times goes on those odds become less likely.

His performance is exceptional when you consider the number of positions he has in his portfolio – I run a much higher concentration than he does. It could be that my historical performance is simply a fluke.

KCG cost of capital calculation

I will warn this is a very dry post.

The merger arbitrage spread with KCG has narrowed considerably.

When the $20 cash merger was announced the shares were trading at $19.75. There is little chance of the deal falling through or there being a superior offer.

Today KCG is trading at $19.88. The estimated close of the merger was reported to be “3rd quarter 2017”. The assumption is the mid-range, or August 15, 2017.

So there are 3.5 months until the deal closes.

12 cents appreciation is 0.6% over 3.5 months, which over the course of 3.5 months implies a 2.1% annualized rate, not compounding. This also excludes trading costs.

Because I had a small cash deficit in my USD account and a surplus in CAD, I’ve sold some shares at $19.88 to make up the shortfall. I placed it at the ask to minimize trading costs, which turned out to be 29 cents per 100 shares.

What’s interesting is my trade got hammered away, 100 shares at a time, approximately 2-4 seconds apart per trade. Interesting algorithms at play here.

I also believe Virtu (Nasdaq: VIRT) will have a more difficult time with the integration of KCG than they originally anticipate. The company cultures are significantly different and while the merger makes sense on paper, in practice it is going to be quite different. KCG was also dealing with a non-trivial data migration program on their own, from New Jersey to New York City and these sorts of technical details require highly skilled individuals to pull off without causing trading blow-ups. It might take them a year to get things stabilized after the merger is finished. KCG had huge growing pains of its own after it was reverse-takeovered by GetCo.

Canadian preferred shares education

James Hymas has published a considerable volume of information concerning fixed-reset preferred shares. It makes for very heavy reading (i.e. this is not something you can casually read at a Starbucks), but if you are in the right frame of mind, there is a ton of educational content that you would never see in your typical MBA program.

He also has an equivalent document for a class of preferred shares that stand a better chance of being redeemed early due to regulatory capital requirements rules which I will not repeat here.

While I’m on the topic of James Hymas, he is very concise with his analysis on the Canadian real estate market, mainly that it is caused by “low interest rates”, “an explosion of CMHC guarantees”, and “unsatisfactory stock market returns”. Capital has to go somewhere and if you can’t get a 4% return from the stock market, you can at least go for a cap rate for the same in the real estate market. I will observe that 5-year bond yields have slipped to the 1.00% level again and 5-year fixed rate mortgage are available for 2.39% on insured mortgages. Why bother to put up any equity when money is virtually being given to you at the rate of inflation?

Psychology of Portfolio Management – Doing half

There are some situations in the investment world that result in considerable confusion and risk.

In particular, I am still trying to process the action that has surrounded KCG Holdings (NYSE: KCG) last week. The position appreciated considerably, but there is obviously not going to be any resolution to the matter unless if I wake up one day and a definitive merger agreement has been signed. If the initial proposal and subsequent due diligence cycle does not come to fruition, then there will likely not be any press to that effect and the stock price will drop.

There is a very real reason to hold on (the suggested merger price was lower than my estimate of its fair value), and a very real reason to not hold on (there will be no formal merger agreement). Also, there is no information at all whether this merger would succeed or not, nor any indications on timing.

So the solution was obvious. Sell half.

David Merkel is one of my favourite finance authors and he concisely writes about it in an April 2009 blog post and a subsequent November 2016 post.

This is a perfect situation where doing half applies. The psychological advantage is that I don’t have to cry if there is a better price given to the company, nor do I have to cry if they trade lower (since I know where their fair value rests).

Researching Primary Market offerings

The market has run so dry, it has finally come to this – I’ve had to resort to looking at prospectuses of primary market offerings.

Questrade has a rather interesting link to offerings that they’re trying to peddle to the unsuspecting public. And being the sucker I am for these sorts of things, I glossed through a couple prospectuses.

Hampton Financial Corporation (TSXV: HFC) is trying to raise $20 million in preferred shares (plus warrants on their common shares that are nearly double the current market price). The preferred shares have a perpetual, uncallable (by either side) 8% yield. The head honcho owns a lifetime control stake in the company (and a decent economic interest) and a very sweet-looking employment contract. Try negotiating this on your employer (I’ve replaced the person’s real name with Mr. CEO as I don’t want to foul up his pristine search engine profile on his name):

“In consideration of Mr. CEO’s services, the Corporation has agreed to pay Mr. CEO an annual base salary of $200,000, which is to be increased by a minimum of 25% each year from the first anniversary of the commencement date of the employment and a one-time cash bonus of $200,000 payable at any time during the first year of the executive employment agreement, at the discretion of Mr. CEO. In addition, Mr. CEO is entitled to receive annual bonuses at the discretion of the board which may be paid in part by shares or equity-related instruments of the Corporation and a perquisite package of $24,000 per annum.”

There’s other stuff in the prospectus that is juicy, but suffice to say, I’m not too inclined to support this particular public offering, especially considering they don’t make money and they have about $3 million in stockholder’s equity. They also have some very interesting lawsuits that have judgements rendered which give a very good insight on the culture of the firm.

Who the heck would invest in this? If it actually sells, it’s certainly a sign that the market is willing to pay for anything with yield.

With most of these offerings, keep your hands on your wallet.

(Update, March 21, 2017: At the request of one of the issuers, I have amended this post.)