Canadian interest rates

The Bank of Canada dropped their target interest rate from 0.75% to 0.5% today.

Canadian currency has taken a plunge in response. In addition the Federal Reserve Chair has pledged to start “normalizing” US interest rates by the end of this year which also puts downward pressure on all non-US currencies.

cdw

While I rarely have strong feelings on currencies, the “perfect storm” for the Canadian dollar is brewing (lowering interest rates, lowering GDP, lowering commodity prices, lowering external trade with China/USA, political uncertainty over the October 19 election) and it appears more likely than not that we’ll start approaching the point where we’ll see some sort of floor on Canadian currency (simply because the news could not get worse). I’m going to guess it will be around 72-74 cents, but we will see. I’d also expect this low to be reached around October and I may make a significant policy change on my CAD-USD holdings at this time given valuation levels.

My working theory is that the US economy is going to have extreme difficulties adjusting outside of a zero-rate environment and the process of deleveraging will be a painful business when hedge funds can no longer obtain money for free (Interactive Brokers, for example, will happily lend you USD at 0.63% for more than a million and 0.5% for more than $3 million). Paradoxically if the 30-year treasury bond decides to spike up from 3.2% to around 3.5% yield levels, I would suspect that purchasing long-term treasuries are going to be the winning play over the next period of time – not any equity fund. Debt levels incurred by the US government are hideously high and with every quarter point increase that they face will be a disproportionate amount of interest expense going out the door.

This also does not factor in other entitlement spending (e.g. social security, medicare, etc.) that serves to effectively ramp up the net expenditures for public debt purposes.

Right now I am mostly cash (or near-cash). Some of my efforts to find a place to park cash have mysteriously yielded results that are relatively low risk and I’ll be able to realize a modest single digit percentage at the cost of a little bit of liquidity, but in the event there are better investment opportunities on the horizon I will be in a very good position to pounce.

Maybe I should have invested in the CPP instead

The Canada Pension Plan reported a 2015 fiscal year-end (their fiscal year goes from April 1 to March 31) performance of 18.7% gross, or 18.3% net after fees.

Over the past 10 years, the CPP has realized a 6.2% real rate of return, while in order to remain sustainable they require a 4% real rate of return. When dealing with a $250 billion dollar fund, two percent compounded over 10 years makes quite a big difference.

I have had my doubts that the CPP would be able to realize increased returns as it grew simply because they are competing with a lot of other big players for the same pool of income. In a smaller scale, individual investors have to scour the beds of the financial oceans in order to find reasonable risk/reward opportunities.

There is likely going to be increased political pressure to either reduce CPP premiums or raise CPP benefits due to the outperformance of the CPP. It is likely such a decision would be a mistake because in the macroeconomic sense, central bank quantitative easing has inflated asset pricing to extremely high levels. It is very improbable the CPP can maintain its current performance and quite probable that they will pull in more “real-world” rates of returns (i.e. single digits).

However, all Canadians should be happy that the CPP is doing what it did – there is this pervasive myth that the CPP will not be able to pay out for existing and future generations and with the existing payment and benefit regime it is quite likely they will be able to pay for the indefinite future. Assuming you have made maximum contributions to the CPP, you would be entitled to a $12,780/year retirement benefit when you turn 65 years of age. While this is not a huge amount of income, when coupled with Old Age Security ($6,765/year) leaves approximately $19,500/year of pre-tax income which, if properly budgeted, will pay for a basic lifestyle in retirement.

Inverted yield curve

The Canadian bond market is exhibiting a very minor instance of an inverted yield curve between short term and 2-year money. You can view interest rates here.

This is a good an indication as any that we’re going to touch upon a zero GDP growth cycle coming later in 2015 and perhaps negative. Pull out the textbooks to see what industries are good to invest in a recessionary climate.

The global race to the bottom

While not as dramatic as the recent decision by the Swiss Bank to forgo keeping its currency at a lower than market value level, the Canadian dollar was the recent victim of a central bank action when the Bank of Canada decided to drop interest rates by 0.25%. The Canadian dollar is down 2 cents to about 80.7 cents USD (or about 1.24 CAD/USD).

BAX Futures were not anticipating this decrease – today, they are are all trading up about 0.3% as a result of the Bank of Canada’s actions.

My general thought is that the Fairfax theory of the global economy is showing itself to be true – deflationary forces are forcing export-driven economies to devalue their currency. The next leg to drop will be the European Union officially announcing their version of quantitative easing, of which has already had negative implications to their own currency. Japan has already been in this mode for a couple years (Abenomics).

The remaining leg will be when/if the US federal reserve decides to implement interest rate hikes. On today’s decision by the Bank of Canada, federal funds futures are relatively unchanged; they anticipate the US federal reserve will raise rates a quarter-point by the end of the year.

This will also create an interesting dilemma for the Chinese government – their economy is highly export oriented and their competitive position continues to be eroded by the macroeconomic decisions of other countries. Whether they choose to slowly deflate the Yuan in reaction to this remains to be seen.

While the cause of the Bank of Canada’s decision is related to the very sudden decline in the oil market, I am wondering whether the country is simply getting carried away in the geopolitical currents that seem to be affecting every developed country at the moment.

Right now I am over 50% exposed to US currency (the rest of it being Canadian), so I am not minding this trend. What I am regretful for, however, is that this will have a material impact on my willingness to go down to the USA for recreational purposes.

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.

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.

Canada issues 50 year debt

The government of Canada today issued $1.5 billion in debt with a 50-year maturity. The yield to maturity is 2.96%. For the duration these are amazingly low interest rates. If the Bank of Canada can actually keep the inflation target pinned at 2%, the real rate of interest is less than a percentage point.

Suffice to say, I think this is a prudent move by the government. I wonder when Canadian banks will come up with mortgage products that will let consumers lock in insured 30-year mortgages for 150 basis points above government rates. They do this in the USA, why not here?

I’m also curious to know how much debt the government can issue with these terms before the public market starts to vomit on this much debt. For every seller (the government), somebody out there must want to be long this debt. There is a financial argument about hedging against market volatility (typically bond prices will rise with a reduction in equity prices) and generating some higher semblance of income compared to 1%-yielding cash, but locking yourself in at 2.96% for 50 years? Unreal.

In a very abstract level, the taxpayers of Canada win in this scenario – as long as the pension fund that is buying the debt isn’t the one paying your future defined benefits.