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.

Q1-2017 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2017, the three months ended March 31, 2017 is approximately +18.6%.

My 135 month compounded annual growth rate performance is +18.6% per year, an identical number that is strict coincidence.

Portfolio Percentages

At March 31, 2017 (change from Q4-2016):

24% common equities (-24%)
20% preferred share equities (-7%)
38% corporate debt (-6%)
3% net equity options (+2%)
15% cash (+35%)

Percentages may not add to 100% due to rounding.

USD exposure: 50% (+8%)

Portfolio is valued in CAD (CAD/USD 0.7508);
Other values derived per account statements.

Portfolio commentary

Needless to say this was a good quarter for me. Normally posting a return like this would be good for a year’s performance. Although I do not invest for relative performance, relative to the S&P 500 (+6% for the quarter) and the TSX (+2%) my portfolio had a smashingly good quarter.

I will warn this performance will not be matched in the next 9 months of this year. The upside potential of the current portfolio components is limited. My estimate of this potential, assuming an above-average ideal of things going correct, is 8%. This means about 2-3% a quarter for the next three quarters, and of course things never run that smoothly in portfolio management, unless if you invested in GICs.

In terms of buying activity, this quarter was relatively inactive (less than a percent of the portfolio). On the selling side, my two largest equity components (TSX: MIC, NYSE: KCG) had considerable rises in price, and as such, I did some significant trimming. They are now down to reasonable proportions of the portfolio. I also trimmed some preferred shares. Also assisting the +15% cash position was the maturity of Pengrowth Energy’s debentures (my initial post about them was here). My portfolio now has a positive cash balance for the first time in about a year.

In contrast, I ended 2016 with a -20% cash balance (i.e. a margin position of 20% of the equity of the portfolio). As you can see, it was time to cash some chips. Cashing in some chips results in capital gains taxes to be paid in the next year, but this is the cost of profitable portfolio management. Taxes are a secondary consideration in trading decisions – valuation is the primary driver. I am relatively happy to see the capital gains inclusion rate did not change in Budget 2017, but I do not take the government at its word at all that it will keep this rate steady.

The other corporate debt in the portfolio has an weighted average remaining term of slightly less than 3 years. The corporate debt will collect interest income and will otherwise sit there collecting dust until maturity or being called. At par value, I am not interested in liquidating them until maturity (or if they are called away). Given the short duration, I do not care if risk-free rates rise.

Portfolio Outlook

The decision to play safe this quarter (and likely for the remainder of the year) is obvious to me. Markets have risen significantly in the Trump honeymoon and I do not believe that risks (specifically the so-called “unknown unknowns“) are being truly appreciated at the moment. Everything is seemingly looking good. Things are comfortable. Look at what happened to the S&P 500 implied volatility after Donald Trump got elected (November 8, 2016):

When everybody thinks things are comfortable, this is a formula for future loss when less optimistic scenarios bakes into market pricing. I am not sure when negative sentiment will pervade throughout the market, but these things will always manifest themselves later than one expects – I am probably too early.

It is psychologically difficult to sell yielding securities for non-yielding cash (why sell something that gives away money for something that just sits there and earns zero?), but I must reload my ammunition for when the market truly decides to go into a tailspin. I don’t know the specific reason for the next tailspin will be (or when), but these things usually do occur when people least expect them. The future is always difficult to predict, but right now when I am looking microscopically across the markets for opportunities, I am drawing so many blanks that I need to crawl to a safe place. It might look foolish to duck into the shelter before there is even an inkling of a hurricane or tornado coming in the horizon, but this is how I feel, so I will bunker down.

I had written earlier in my 2016 year-end report that if everything goes well this year I should probably see a low-teens performance. Because of some unexpectedly positive developments in my two largest portfolio components, I have already made a year’s worth of gains in a single quarter. I will repeat that while one can extrapolate this quarter’s performance to future quarters, I would advise it would be a significant error to do so – there is no way this can continue. As I continue to cash up, it will continue to cap my performance gains. If markets rise to my additional sell points, the amount of cash can go 50%, which is a ridiculously high amount. I am also content to hold cash or cash-like instruments for extended periods of time.

Just imagine showing up to work in a finance firm as an asset manager and telling your bosses that you’re holding cash and going to watch movies until the markets drop. While I am not that lazy (I do run occasional stock/bond screens and try to look at the microscopic parts of publicly traded securities which are less prone to overall market fluctuations), when I do some detailed due diligence, it mostly ends up flat. Even worse yet are the IPO and secondary offerings that are hitting the market – there’s a lot of junk being shoved out the door to yield-hungry investors. It reminds me of what they did with the income trusts in the early 2000’s (most of them blew up and lost a lot of people money, other than investment banks and management insiders).

Sadly, market conditions and the selling nature of my portfolio at present means my writing will become more boring until things become more volatile. I recognize this is my shortest quarterly commentary in quite some time – I’m finding little to invest in.

My next challenge is to find a good location to park cash.

Some macroeconomic outlooks

I do have a few convictions that surround my decision-making (or lack thereof). One is that I am of the belief that the US dollar is undervalued and should perform relatively well against other world currencies, including the Canadian dollar. I have generally maintained a policy of keeping the US dollar exposure of the portfolio between 30-70%.

The other conviction I have is that I believe crude oil will continue to be a mediocre performer and indeed, in any sign of any world economic malaise, will take a tailspin from their existing price band. This makes Canadian oil producers (especially in the existing hostile federal and provincial environments) relatively prone if they have debt pressure, especially those contingent on higher oil pricing. At present, a lot of these companies have “value trap” written all over them. A good example will be Cenovus (TSX: CVE), who decided to leverage up, but just imagine the stress their shareholders will feel at US$40/barrel instead of US$50/barrel today. There will be a time to invest in fossil fuels, but not now.

Political outlook

My home province of British Columbia is having an election. Although I project the incumbent party is going to continue to win another majority government, there is a strong anti-incumbency undercurrent which appears to be brewing, which will make motivational aspects of elections (i.e. turnout) crucial. I am not nearly as certain as the result as I was at the beginning of this year when I projected the existing government would cruise to an easy victory.

The main opposition party, the BC NDP, still doesn’t appear to have their act together (I don’t see them focusing on issues that will actually win them the election), but this campaign is going to be quite volatile since the public is only going to pay attention during two weeks of the election period before deciding who they will vote for.

It doesn’t matter how incompetent the BC NDP have looked in the past, it matters how competent they look in exactly those two weeks when the public care.

Portfolio - Q1-2017 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
11.25 Years (CAGR):+18.6%+5.8%+8.1%+2.9%+5.8%

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:


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:

TLM.TO (not that they’ve been having difficulties lately!)
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.

Raising cheap debt capital

Cenovus Energy (TSX: CVE) raised $1.25 billion in debt financing today. Here were the relevant terms:

AMT $500 MLN    COUPON 3 PCT       MATURITY     8/15/2022
TYPE NTS        ISS PRICE 99.129   FIRST PAY    2/15/2013
MOODY'S Baa2    YIELD 3.102 PCT    SETTLEMENT   8/17/2012   
AMT $750 MLN    COUPON 4.45 PCT    MATURITY     9/15/2042
TYPE NTS        ISS PRICE 99.782   FIRST PAY    3/15/2013
MOODY'S Baa2    YIELD 4.463 PCT    SETTLEMENT   8/17/2012   

So they can raise 10-year money at 3.1% and 30-year money at 4.46%. After taxes (assume 26%) this is about 2.3% and 3.3%, respectively. At these rates, I’d be raising as much 30-year capital as I can and figure out what to do with it later – there has to be a way to deploy it at a better pre-tax return rate of 4.46%.

The easy trade is the dangerous trade

The easy trade these days appears to be in crude oil, and to a lesser degree, commodities.

My trading gut instinct says that the crude market may be a tad overextended at the moment, presumably due to geopolitical instability.

Modern historians should note that Iran and Iraq went through a decade-long war, yet the Persian Gulf still managed to export billions of dollars of crude.

The big shoe to drop is the answer to the question of “What happens in Saudi Arabia?” since they control a significant source of supply globally. That said, it is highly likely that the oil will still flow since whoever is left to control government will still want the cash cow – what will be significantly more disruptive is that the incumbent administration knows it will be kicked out, but has plenty of notice of its pending demise. In this scenario, they will likely use the “scorched earth” option, similar to what Saddam Hussein did in Kuwait prior to the first Iraq invasion.

Readers will likely note that their holdings in Canadian oil sands related companies have received a significant amount of appreciation over the past 6 months – partly related due to the market conditions and improving economy. Here is a chart of Cenovus (TSX: CVE), but you can pretty much fill this in with the usual suspects (Suncor, Canadian Natural, etc.):

The last spike up over the past month is a function of higher crude prices and geopolitical instability – I’d estimate of the $6 that it has gone up from $32 to $38, half of that is due to crude, and half of it is implied instability.

That said, it seems like an easy trade to pile in at the moment, so be very cautious – when others think alike, your risk/reward ratio becomes more adverse.

Price of crude

It is an important benchmark to see that the price of crude oil is at an all-time high, at least in nominal US dollar terms, since the economic crisis:

Every day when I look around me, I see people in their automobiles, and I see trucks on the road, and airplanes flying in the sky. While the sample of one is statistically insignificant, when you start to think about world-wide demand for concentrated portable energy (which is what crude oil represents), coupled with the increasingly high costs to mine supply, leads one to suspect that hedging their energy consumption in the form of owning energy assets would be a prudent portfolio decision.

This isn’t new – I have been discussing this for the past couple years. I believe in crude much more than gold in terms of hedging your purchasing power.

Large-cap oil sand companies like Suncor (TSX: SU) and Cenovus (TSX: CVE) are highly correlated to the price of crude oil. They also have significant bitumen reserves which become increasingly valuable as the price of crude rises. Due to the nature of the financial structure of these companies, they are not going to double overnight, but they will retain their value as long as you believe in the stability of the Canadian and Alberta governments.

Companies with oil assets outside “safe” jurisdictions (e.g. Venezuela) involve much more risk, hence you will find them cheaper.

There are also some other smaller cap companies in the oil sands space that are worthy of consideration, and they contain a bit more financial leverage which would result in potentially larger gains.

Oil company valuation – general note

Most oil producing companies also produce natural gas. Since natural gas is an input to gasoline production, typically companies internalize their natural gas production to their operations. However, many oil and gas companies produce excess natural gas and this contributes to their income.

Watch out for some earnings disappointments due to lower natural gas prices. Cenovus (TSX: CVE), for example, announced less than consensus earnings this morning due to natural gas pricing. Another company that is due to report that has significant natural gas production is Arc Energy Trust (TSX: AET.UN).

I am just a passive observer of these two companies, in addition to many others in the sector. There are nuggets of value here and there, but all of those are in the non-dividend bearing category. Companies like Cenovus (and its sister entity, Encana) are good stores of value in energy, but are unlikely to triple in valuation if energy commodities increase. They should almost be treated like annuities, assuming fossil fuels are not supplanted by something with superior energy density in the future (not in my lifetime).

Steam-Assisted Gravity Drainage

Anybody investing in oil should know the fundamentals of how the oil is extract out of the ground. The traditional (called conventional) method is used in places like Saudi Arabia – sticking a tube in a strategically-located position in the ground and sucking up the contents.

Steam-Assisted Gravity Drainage was an invention that has lead to the opening up of oil reserves that otherwise would have been inaccessible. There are quite a few companies in the Alberta area that use this to mine oil. A very basic example of how this works is on Cenovus’ website, which is semi-education and semi-corporate propoganda.

Cenovus used to be part of Encana, Canada’s largest natural gas producing company. They split off last year.

The other form of mining, taking tar sands (bitumen) from the surface and processing the material, is done by companies such as Suncor, and generally give the industry a perception of being environmentally damaging.

As the price of oil continues to increase, alternative methods become increasingly economical and it is well worth it for an investor to educate themselves on the processes used to extract energy from the earth.