Mid-stream oil and gas

Low oil prices hurt producers for obvious reasons.

They also are hurting the mid-stream, but this is for less obvious reasons – low prices means curtailment of capital expenditures, which typically mean lower volumes, which means less money for midstream producers. Volume is the dominant variable for the mid-stream, not prices.

The flip side of this equation is lower prices stimulates consumption, which means higher oil prices, which means higher capital expenditures… you get the picture. There is an equilibrium factor that depends on mutually dependent factors in order to “solve the equation”. In Excel, this would typically be a circular equation, but when applied in real life, the input variables are much more fuzzy, and thus it makes the output chaotic and difficult to predict where the true “landing spot” is (which never exists – it is always ever-moving).

The other clear factor is that when oil and gas companies are not making profits, there is an element of counterparty risk.

One broad-brushed way of investing in the US mid-stream sector is through the Alerian MLP ETF (AMLP) which got killed yesterday. The constituent companies are fairly stodgy oil and gas pipeline MLPs which give out most of their income in the form of distributions. Normally MLPs are very adversely taxed for Canadians, but the AMLP structure is a corporation. It distributes its income mostly in the form of a return on capital, but for tax purposes, it is equivalent to foreign income. However, in a registered account, this is a non-factor. At the low of $4.14/unit, it was trading at a yield of 18% and even when factoring in the inevitable decline of shale production in the USA, seems to be a reasonable risk-reward proposition as investors seek yield.

To a lesser degree, Canadians can also invest in Enbridge (TSX: ENB), TransCanada (TSX: TRP), Pembina (TSX: PPL), and for those interested in Albertan intra-provincial pipelines, Inter-Pipeline (TSX: IPL). However, the income to price disparity is not nearly as present as the American analogs (including Kinder Morgan, Williams, etc.).

Pembina, in particular, has gotten killed simply because it faces a risk that the Trans-Mountain pipeline is not going to be constructed, especially with the crash in oil prices and the general incompetency of our Trudeau-led federal government. The assets they picked up from the old Kinder Morgan Canada were quite good. Enbridge and TransCanada should also do well – the big loser going ahead will probably be the oil-by-rail trade – if production slows down, this volume will be the first to get scrapped, not the pipelines.

The new market paradigm

Longer term interest rates have gone to nearly zero.

I won’t quote the yield curve but suffice to say at the March 17-18 Federal Reserve meeting, they will drop the federal funds rate another half point to a target of 0.50% to 0.75%, or perhaps even to 0.25% to 0.5%.

Either way, this is close enough to zero.

After the 2009 economic crisis the yield curve more or less did the same thing (except yields were slightly higher). The name of the game was the following: Anything with a yield is an eligible investment. Anything without a yield is trash.

The trick, as always, is to ensure that the companies that you’re investing in have the organic cash generation capability to give out those yields.

Those that can buy sustainable yield will do well. Those companies that don’t give out yield will probably trade at a discount to those that do, except for those that are of speculative value (the Teslas and the like).

Finally, using my “Coronaproxy” stock, Alpha Pro Tech (NYSE: APT), it looks like the hysteria is dissipating. Be warned that I’ve been so wrong on the psychological impact that this flu has had on society that I don’t blame the readers of this site for using me as a contrary indicator.

Coronacrash #4 – this time in crude oil

Crude oil is down the biggest percentage I have seen in my investing history – West Texas Intermediate (WTI) currently down 20% (from a close at US$41 to US$33 presently). Brent is about US$37. There is no way to describe this other than a crash.

Canadian oil has been trading at a heavy differential, with Western Canadian select closing last Friday at US$28/barrel.

Needless to say, this is going down on Monday, probably to around US$22/barrel if we keep things at a 20% discount to WTI.

There is no Canadian oil company that can survive at this price level. Even though there are some companies where this is under the marginal cost of extraction (e.g. looking at CNQ’s last year, they had a CAD$12.41 marginal cost of extraction for their North American production, not including royalties) you still have costs associated with drilling and financing to pay off, and a US$22/barrel model completely destroys this.

Some obvious implications are that capital spending is going to decrease to the bare minimum, even more so than what has previously been announced. High cost production is going to be shut down, and we will be seeing another wave of insolvencies in the energy sector. Not pretty at all.

In these high-volatility situations, there is always money to be made by correct timing and correct decision-making, and right now the winners are those that don’t have a single barrel of crude oil in their portfolio. There will be spillover, however, plenty of it.

For example, geopolitically, countries that are heavily reliant on crude imports can’t continue to function for very long. Iran, for instance. Rock-bottom crude oil prices will have ripple effects that are not immediately obvious on a first order level of thought.

Constellation Software – valuation

There is no doubt that (TSX: CSU) is well-managed and the CEO’s instincts on return on investment from acquisitions is spot-on. Software has a “sticky” component where the cost to transition systems is so high that it creates a barrier to entry. With existing licensing regimes, it can create recurring revenues that can be increased over time (especially for institutional customers – much less price sensitive than consumers).

Glossing over the year-end results, this is what I see (from the cash flow statement) – note this is a really crude, paper-napkin styled analysis:

The balance sheet in relation is fairly neutral – they gave out $500 million in dividends in 2019 which impacted the cash balance, in addition to spending nearly $600 million on acquisitions. Despite this they still have about $100 million net cash on the balance sheet (and another roughly $250 million in lease obligations). Thus, I’ll ignore the balance sheet since this is obviously a cash flow valuated concern.

We use the $633 million number (the 2019 run-rate for free cash generation), divided by 21.2 million shares outstanding. This gives us about $30/share.

(An original post completely forgot about the fact that CSU reports in US dollars when their stock trades in CAD, so the numbers below have been corrected as appropriate, with some mild embarrassment for my own distraction as I was looking at the crude oil futures)

CSU’s last trade was at US$995 per share, which gives a 33 times valuation.

Let’s say they can grow earnings at 15% a year (ignore all the myriad forms of assumptions that would go into this), they will need about 3-4 years growth at that rate to get to a 20 times valuation with their stock price being constant.

That seems to be relatively expensive. Who knows, they might be able to grow faster than that.

CSU is good at what it does, but quality comes at a high price. The question is whether that price will get higher, either through growing the bottom line or a continued expansion of the price to cash (or earnings) ratio.

Coronapanic Update 3

We’re not even close to the panic “Federal Reserve is going to strangle the economy with rising interest rates coupled with end of year tax loss selling” bottom of 2018:

The flu, which tends to kill an estimated 100 to 200 Americans a day, depending on the year, is now the trigger to a market panic.

Perhaps Coronavirus is the excuse for what was a stretched market – although its real-world effects is probably in-line with past happenings, the psychological effects have spiraled into something that is now turning into real-world effects that will take the better part of a year to digest.

People are staying home, events are being cancelled, there’s mass panic at Costco for toilet paper (rationally speaking, toilet paper is quite a bit down on the list of things you’d want if the world is going to end), and travel plans are being suspended. In China/Hong Kong, kids are staying home and not going to school, and needless to say, this is going to have an impact on consumption. It’s got recession written all over it.

There’s been an obvious rush for liquidity, and the next ripples to emerge will probably be in the corporate debt markets as covenants get breached due to shortfalls in revenues/EBITDA amounts.

I’d be really cautious about companies that have credit lines that have covenants that were close to being reached in the last quarter.

Likewise, companies that are requiring rollovers of debt will be facing a very uncomfortable situation.

I recall the 2008 days when companies like Sprint Corporation and other reputable corporations had their long-term debt trading at 20-25% yields to maturity. Will we get to that point?