The easy trade is rarely the best one

Canadian Oil Sands (TSX: COS) had a wild day after their year-end report and upcoming projections for 2015.

2015-01-30-COS.TO

Traders clearly were panicked at the beginning of the day and when they all cleared the exits, the stock rocketed upwards.

The amount of volatility we are seeing in the Canadian oil and gas sector is indicative of the volatility typically seen in down points in the market (see 2008-2009 for a good example of this), but these scenarios typically take months to finish and not days. Of course you have to be there exactly at the day the S&P 500 hits 666 in order to catch the absolute bottom, but the right trade at the time should feel painful.

Right now buying into oil seems like the right thing to do, but the trade doesn’t feel painful to make. This makes me very cautious and I will continue to wait.

The other item I am looking for is that audited financial statements are due on March 31st, although companies typically report them earlier. Loan covenants are going to be tested against these numbers and it will be obvious which players out there will be over-leveraged.

The other comment I will make is that most producers seem to be in a waiting game – even Canadian Oil Sands projects a WTIC price of US$55/barrel in their 2015 overall projection. Right now WTIC is at US$47 (the December 2015 crude future is at US$56) so we are not too far off that projection, but the financial modelling of all of these companies (and even the Government of Canada) has an upward bias to commodity pricing. What if this doesn’t materialize? As company hedges (note that COS does not engage in hedging) start to expire and companies have to really start digging into their balance sheets to remain operating at existing production levels, eventually you’re going to see production decreases. Only until then it seems the fundamentals will sufficiently shift toward higher oil prices.

The trade at that time, however, will be painful. Only then will investors see a superior reward on their investment.

The same applies to currency markets. Right now going against the US dollar seems like stepping in front of a freight train at full speed. I’ll be unwinding some US currency exposure if the Canadian dollar depreciates a little more.

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.

Q1-2012 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2012, the three months ended March 31, 2012 is approximately -3%.

Portfolio Percentages

At March 31, 2012:

14% Equities
86% Cash

USD exposure as a total of the portfolio: 22%

Portfolio Commentary

A severe underperformance of the main indices – The S&P 500 was up 12% for the quarter, the TSX was up 4%. The lack of performance dealt with baggage concerning Yellow Media and other lingering items which have hence since been disposed of. The only unfortunate aspect of this is that the cheque from the government to offset the capital gains made in previous years will only be coming in April of 2013. It was a high-risk, very high reward-type bet and when you place some money on these types of ventures, you should always be prepared to take losses and that I did.

With 86% in cash, there really isn’t a heck of a lot to talk about – the 14% I do have in equity is primary in two US companies. One can be considered to be a “value” play, a company that had about two-thirds of its market cap in case, but has a business that has stable revenues and should be able to produce earnings once they learn how to cut their marketing expenses. There are growth avenues for their product line, but it should be considered a mature industry. The company has a good name brand and the target market is not going to disappear.

The other company is a growth candidate that is in a technology-related field that I am very familiar with and have done plenty of homework a few years ago on it. Only now did the stock crash sufficiently on an announcement, which I considered to be ordinary for the business but the investors obviously did not, to a valuation where it was worth picking up shares. Unfortunately I did not receive my desired fill in this or the other candidate when they were trading at relative low prices, but I will be patient and we will see. This is not a get-rich-quick stock, but it is a company that has had a very solid track record since going public of increasing revenues and earnings in a lumpy fashion – and currently these lumps have a downward trajectory.

I was aiming for an initial 10% weighting in both companies but instead got less.

While I am not that happy to see the portfolio stagnate, especially in the context of a rising broader market (fueled by the likes of Apple), I take solace in the fact that I have a mostly “blank canvas” for the portfolio and that I have not made mistakes by forcing money to be invested.

Outlook

I have been severely time constrained this quarter from researching as many investment candidates as I wanted to, but when I do have the time I continue to focus on companies that are not giving out dividends, or giving out very low dividends, both in the USA and Canada.

I remain quite cautious with respect to commodity-related companies, and I continue to be mystified with the price of natrual gas compared to oil – how long will it be before we start seeing gas to liquid energy conversion projects that will finally be able to address supply issues in the natural gas market? The easy and low-volatility play in the natural gas market continues to be Encana (TSX: ECA), but you wonder how long the supply glut is going to last? At $2.20/GJ the margins are simply not there to make huge amounts of money.

I notice industry stalwarts like Canadian Oil Sands (TSX: COS) continue to lag the market despite relatively high oil prices. They were recently able to get a 10-year bond financing out at 4.5% and 30-years for 6.0%. Plays like these all have the investor assume the underlying commodity will continue to be worth more than what the futures prices say.

The low interest rate environment continues to force people to invest in increasing marginal areas – I notice on my yield scans that almost everything with a yield is bidded up to the roof. Generally this is a great formula to generate income but generate even greater amounts of capital losses. The time to play for yield was in late 2008/early 2009 and while I am glad I cashed in on that opportunity, I realize it is not going to happen again for a long, long time.

Long-term interest rates have crept up somewhat – 10-year Canada government bonds have creeped up from the 2% floor to slightly higher. I am not sure whether this is the start of a trend toward higher long term rates or not, but something I am observing. Whenever long term rates do rise, it will create its own financial repercussions as the yielding securities I mentioned previously will inevitably look less attractive.

I remain economically cautious – zero interest rate environments create strange excesses that are quite difficult to predict how they resolve – the inflating asset prices we see today are a function of cheap financing. Regrettably this also includes most of what is available in the stock and bond markets as the thirst for yield continues. The path forward in terms of how this ends is not so clear.