Pengrowth executes an asset sale

Pengrowth Energy (TSX: PGF) managed to execute an asset sale on its conventional production property north of Edmonton, the Swan Hills assets for CAD$180 million.

The debt profile at December 31, 2016 looked like this:

Right now the CAD/USD ratio is 0.75.

At the end of December 31, 2016 they also had CAD$287 million cash in the bank, plus another CAD$250 million for the 4% gross royalty sale on their Lindbergh asset.

They will be redeeming CAD$126.5 million in convertible debentures on March 31, 2017. They also have redeemed US$300 million of their 2017 debt maturity, and will redeem the rest after this transaction concludes at the end of May.

The company announced that after this sale, they have a pro-forma net debt of CAD$970 million.

My math suggests that after the 2017 redemption, they would have CAD$57 million cash left, assuming their operations consume zero cash (not a correct assumption!).

Payment of the debt will result in an interest expense decrease of $42 million per year.

They still need to have CAD$368 million on-hand on August 2018 in order to pay off their next debt maturity. It is possible they will run into covenant issues given that oil hasn’t moved around the US$50/barrel mark – their existing senior debt to adjusted EBITDA ratio would be the most material of it. They have about CAD$1.02 billion outstanding and their EBITDA needs to be above CAD$290 million in order to clear this hurdle.

Although the EBITDA value for covenant purposes was CAD$582 million, this is a skewed figure due to the employment of hedging. People not versed in accounting procedures for commodity hedging will have a tough time figuring out the mess, but I will just point out that management closed out their hedges in 2016 (which had been a VERY profitable transaction to them that otherwise would have guaranteed CCAA had they not had the foresight to doing so when times were much better).

Pengrowth Energy – dodged a bullet

Pengrowth Energy’s debentures (TSX: PGF.DB.B) will be redeemed on March 31, 2017 and the company has also announced it will be redeeming USD$300 million in senior debt (announced February 21, 2017).

I own the convertible debentures and will miss their presence once they mature. I’m probably one of the few people that invested in the company and actually made money.

They also announced their year-end results on February 28, 2017. The operations of the company are fairly simple to understand – they are losing a relatively small amount of cash in the existing oil price environment, which they assume is at WTIC US$55/barrel and a 0.74 CAD/USD rate. Management has made some good decision-making on their oil hedges, but they have now closed them (for cold hard cash) and are completely at the whim of the oil commodity markets.

If you take their 2017 guidance to heart, you will end up with $195 million in “funds flow through operations”, a non-GAAP metric that is a proxy for operating cash flow excluding the impact of financing expenses and remediation. The GAAP statements are a mess to read because of derivative accounting (for oil price hedges), exchange rate adjustments, and require some mental massaging to be read properly.

All things considered, the corporation is not in terrible shape.

This is, however, except for the debt maturities coming up which need refinancing.

The company did have a $1 billion credit facility at the end of 2016. It was untapped, probably because the credit facility has a covenant similar to the senior debt. I believe the original intention of management was to use the credit facility to pay off the senior debt as it became due.

The corporation pre-announced in Q2-2016 that if oil prices continued their relatively low level, that they would be potentially in breach of their covenants. What was new in the Q4 announcement was that they alleviated their senior debt (before working capital) to book capitalization ratio covenant, at the expense of amending the debt agreement to redeem senior debt in the event of asset sales and also to reduce the ceiling of their credit facility to $750 million.

There are three other covenants remaining that an investor needs to pay attention to. The most material of them is the senior debt before working capital to adjusted EBITDA ratio, which ended at 3.1 in 2016, but needs to be below 3.5.

Pengrowth, to its credit, walked investors through their covenant calculations (page 10 of their MD&A). Doing some pro-forma (after debt repayment in the end of March) analysis, we have about $1,250 million in debt for covenant purposes, which means adjusted EBITDA needs to be above roughly $360 million for them to clear the mark. They did $581.6 million adjusted EBITDA in fiscal 2016, which gives them a relatively healthy margin of error – even though guidance is taking their production down about 10% for the year despite $120 million in projected capital expenditures.

So as long as oil prices don’t crash, they’ll probably use the credit facility to pay off the remaining US$100 million in debt due in July 26, 2017. The next major maturity is CAD$15 million + US$265 million on August 21, 2018, and if nothing changes between now and then, they will use the credit facility to pay that off. At that point, they will have about CAD$500 million utilized in their facility, plus the (presumably negative) amount of cash flow they burn through operations in the next couple years.

If oil does slip, there is a point where they will get into covenant trouble.

They did note in the MD&A:

After the above debt repayments, Pengrowth anticipates it will remain in compliance with its covenants through the end of 2018. In order to comply with certain financial covenants in its senior unsecured notes and term credit facilities through 2017 and 2018, Pengrowth has run a scenario, that accesses the capital markets before the end of 2017, and includes an improvement in realizations for oil and natural gas.

They will probably tap the asset market to give them a higher degree of comfort. This is what Penn West did when they gave up their Saskatchewan operations to stabilize their balance sheet.

In retrospect, I think the company erred in not using shares to repay the convertible debentures – they probably should have bit the bullet and increased their margin of safety by cheaply equitizing the convertible debt. Now, management is basically gambling that oil will be going up in the next couple of years and are basically playing a waiting game.

Pengrowth Energy Debentures – cash or CCAA

A quick research note. Pengrowth Energy debentures (TSX: PGF.DB.B), something I have written in depth about in the past as being one of the easiest risk/reward ratios in the entire Canadian debt market, has reached the “point of no return” with regards to its redemption. They are to be redeemed on March 31, 2017 for cash (and an extra half year of accrued interest at 6.25% annually). For the company to exercise its option to redeem them for shares (of 95% of TSX VWAP), they needed to give 40 to 60 days of notice from the redemption date.

(Update, February 21, 2017: Pengrowth announced they will be redeeming the debentures on maturity at March 31st. Also on their senior debt covenants, it looks like somebody is trying to steal the company… they might be forced into making an equity offering.)

My math says that the next market opening, February 20, 2017, will be 39 days before March 31st.

Barring some sort of mis-interpretation of the legalese, this means that the company must redeem this debt (CAD$126.6 million) for cash. The alternative is CCAA, which I do not deem is likely considering Seymour Schulich would likely have something to say about that particular option (he controls 109 million shares or 19.9% of the company at present). There is no longer any time to negotiate an extension with debenture holders.

This debenture issue was acquired as a result of the NAL acquisition back in 2012. It was originally CAD$150 million but they company repurchased some at a considerable discount to market earlier this year.

Pengrowth is in the middle of a silent negotiation with their senior creditors as they are in covenant troubles. Their senior creditors will no doubt be unhappy with the fact that some company cash is going towards a junior creditor.

Sadly I have no good candidates for re-investment at this time. Suggestions appreciated.

Pengrowth Debentures – To be redeemed

(Update, December 21, 2016: The proposal was shelved because PGF’s senior debt holders did not want cash to go to junior creditors.)

A short couple months ago I wrote an article about a “very likely 12% annualized gain” in the form of buying (TSX: PGF.DB.B) at 97 cents.

So it looks like I gave up that return (at least with some idle cash holdings, I do have a position from far cheaper prices earlier this year) as management announced today they are seeking consent from debtholders to allow the company to redeem them as if they have matured on March 30, 2017 (i.e. you’d get about 3 months of accrued interest paid out to you immediately).

So it looks like debtholders will be paid off at $1.03116 per dollar of debt. The redemption will occur on December 30, 2016.

The choice of getting paid today vs. getting paid the same amount in three months is a no-brainer: take the money today and move on.

I have no idea where I will re-invest the proceeds. There was nothing nearly as “safe” as this specific debt issue. Any suggestions out there?

Turning down a very likely 12% annualized return

There is a catch to the title – the 12% annualized return is in the form of a 6.6% return over six and a half months.

I have mentioned this before (at much higher yields) but Pengrowth Energy debentures (TSX: PGF.DB.B) is probably the best low-risk/medium-reward opportunity in the entire Canadian debt market today. At the current price of 97 cents (plus 5.5 months of accrued interest payments), you are nearly guaranteed to receive 100 cents plus two interest payments of 3.125% each. The math is simple – for every 97 cents invested today (plus 5.5 months coupon which you’d get 6 months back at the end of September), you will get 103.4 cents on March 31, 2017, the maturity date. This is a 6.6% return or about 12% annualized.

By virtue of Pengrowth’s debt term structure, this one gets the first crack at being paid by their billion-dollar credit facility which was untapped at the last quarterly report.

The only risk of any relevance is that the company will opt to exchange the debt for shares of PGF at 95% of the 20-day volume-weighted average price, but considering that the debenture face value is $126 million vs. the current market cap of $1.1 billion, the equity would not incur too much toxicity if management decided to do a virtual secondary offering at current share prices.

The company did give plenty of warning that at June 30, 2016, current oil/gas price levels and a 75 cent Canadian dollar would result in them potentially blowing their covenants in mid-2017. But this is of little concern to the March 31, 2017 debenture holder. They will get cashed out at par, either in cash or shares.

I own some of these debentures, which I purchased earlier this year when things were murkier and much more attractively priced. Given some recent liquidations in my portfolio, I could have reinvested cash proceeds into this apparently very low risk proposition. But I did not.

So why would I want to decline such a no-brainer opportunity and instead funnel it into a short-term bond ETF (specifically the very-low yielding Vanguard Short-Term Canadian Bond Index ETF at TSX:VSB)?

The reason is liquidity.

In any sort of financial stress situation, debt of entities that are “near guarantees” are traded for cash, and you will suddenly see that 97 cent bid moved down as entities are pressured to liquidate. For securities that are precious and safe, such as government AAA bonds, there is an anti-correlation to market pricing that occurs and ETFs holding these securities will be bidded up in response.

VSB is not something that you are going to see move up or down 5% overnight in a real panic situation, but it will retain its liquidity in stressful financial moments. The selection of VSB is different than the longer-term cousin, which has more rate sensitivity, but something has changed in the marketplace where equity and longer term debt asset classes have decided to trade in lock-step: as demonstrated in last week’s trading in Japan and the Euro-zone. When equities and long-term government debt (nearly zero-yielding, if not negative) trade in the same direction, it gets me to notice and contemplate what is going on.

The tea leaves I have been reading in the market suggest something strange is going on with respect to bond yields, the negative-interest rate policies and their correlation to equities. I’m not intelligent enough to figure it out completely, but what I do know is that putting it into so-called “low risk” opportunities like Pengrowth debentures come at future liquidity costs in cash if I needed to liquidate them before maturity. Six and a half months can be a long time in a crisis situation, and we all see what is going on in the US President Election – markets are once again seriously considering Donald Trump’s election now that Hillary clearly isn’t healthy enough to be Commander-in-Chief of the US Military. The public will ask themselves: If she can’t stand up to attend a 15-year memorial of 9/11, what makes you think she will be able to stand up when the terrorists strike the homeland again?

The markets have vastly evolved since last February where things were awash in opportunities. Today, I am seeing very little that can be safely invested in, which is getting me to change what I am looking for, but also telling me that I should relax on the accelerator, raise cash, and keep it in a safe and liquid form until the seas start getting stormy again. And my gut instinct says exactly that: winter is coming.

A very quiet May and some self-reflection

It has been a relatively calm month of May for me – I know the cliche of sell in May and go away has resonated in my mind, but my positioning is still quite defensive (very heavily weighted in preferred shares and corporate debt). One advantage of such a defensive portfolio structure is that it is relatively insulated to equity volatility.

The past three months have seen quite a significant performance gain and when there are gains this large I always ask myself whether it is sustainable. When I look at the fixed income components of my portfolio, I see higher room for appreciation from current levels as markets continue to normalize. For whatever reason, Canadian markets were heavily sold off in early February, especially in the fixed income space, and we are still continuing to see a normalization of these valuations.

There were a few missed opportunities on the way. I will throw out a bone for the audience and mention I was willing to pounce on Rogers Sugar (TSX: RSI) when it was going to trade below $3.75/share, but clearly that did not happen (sadly, its low point was $3.84/share) and it has rocketed upwards nearly 50% to $5.71 presently on the pretense that Canadians are going to have a sweeter tooth for sugar rather than corn sweeteners in the upcoming months (which is true – their last quarterly financial statements show an uptick in business and this should continue for another year or so and the market has priced this in completely).

My overall thesis at this point is that the aggregate markets will be choppy – there will not be crashes or mega-rallies, but there will be lots of smaller gyrations up and down to encourage the financial press that the world will be ending or the next boom is starting. When looking at general volatility, the markets usually find something to panic about twice a year and we had a large panic last February. The upcoming panic would likely deal with the fallout concerning the presidential election.

If net returns from equity are going to be muted, it would suggest that the best choices still continues to be in fixed income. The opportunities at present are not giving nearly as much of a bang for the buck in terms of risk/reward, but there are still reasonable selections available in the market. A good example of this would be Pengrowth Energy debentures (TSX: PGF.DB.B) which is trading between 94 to 95 cents of par value. Barring crude oil crashing down to US$30/barrel again, it is very likely to mature at par on March 31, 2017. You’ll pick up a 6% capital gain over 10 months and also pick up some interest at a 6.25% coupon rate. Worst case scenario is they elect a share conversion, but with Seymour Schulich picking up a good-sized minority stake in the company, I very much doubt it. (Disclosure: I bought a bunch of them a couple months ago at lower prices).

In the meantime, I am once again twiddling my thumbs in this market.

Pengrowth Energy Debentures

This will be a short one since my research is done and my trades have long since executed. I will not get into the sticky details of the analysis.

Pengrowth Energy has CAD$137 million outstanding of unsecured convertible debentures (TSX: PGF.DB.B), maturing March 31, 2017. The coupon is 6.25%, and the conversion rate is CAD$11.51/share (which is unlikely to be achieved unless if oil goes to $200/barrel in short order).

Because of what has been going on in the oil and gas market, the debt has been trading at distressed levels. It bottomed out in January at around 47 cents on the dollar (this was a one day spike on a liquidation sale), but generally hovered around the 60-65 level. It is trading at 88 cents today.

It is much, much more likely than not it will mature at par.

There are a few reasons for this.

The debentures are the first slice of debt to mature. Pengrowth’s capitalization is through a series of debt issues with staggered maturities.

Pengrowth has a credit facility which expires well past the maturity date and is mostly under-utilized and can easily handle the principal payment of the debentures.

Pengrowth’s cost structure is also not terrible in relation to the operations of other oil firms.

Today, Seymour Schulich publicly filed his ownership of 80 million shares of Pengrowth, which equates to just under 15% of the company. Seymour Schulich owned 4% of Canadian Oil Sands before it got taken over by Suncor, so I’m guessing he was looking for another place to store his money in the meantime. I think he picked well. Schulich also owns 42 million shares (28%) of Birchcliff Energy (TSX: BIR), so with these two holdings, he owns a very healthy stake in both oil and gas.

This last piece of information seals up the fact that barring another disaster in the commodity price for oil that the debentures will mature at par. The only question at this point is whether they’ll redeem for cash or shares (95% of VWAP), but I am guessing it will be cash.

Even at 88 cents on the dollar, an investor would be looking at a 13.6% capital gain and a 6.25% interest payment for a 1 year investment. This is under the assumption there is not an earlier redemption by the company.

I was in earlier this year at a lower cost. I will not be selling and will let this one redeem at maturity.

A nice time to be holding cash

This is a rambling post.

Downward volatility is the best friend of an investor that has plenty of cash.

You will also see these punctuated by magnificent rallies upwards which will get everybody that wanted to get in thinking they should have gotten in, until the floor drops from them again which explains today.

By virtue of having well over half cash and watching the carnage, I’m still not finding anything in fire-sale range except for items in the oil and gas industry which are having their own issues for rather obvious reasons. Examples: Penn West (TSX: PWT) and Pengrowth (TSX: PGF) simultaneously made announcements scrapping and cutting the dividends, respectively, and announcing capital expenditure reductions and their equity both tanked over 10% today. Crescent Point (TSX: CPG) had a fairly good “V” bounce on their chart, but until oil companies as an aggregate start going into bankruptcy and disappearing, it is still going to be a brutal sector to extract investor value from.

I just imagine if I was one of the big 5 banks in Canada and having a half billion line of credit that is fully drawn out in one of these companies. Although you’re secured, you don’t envy the train wreck you have to inherit if your creditors pull the plug.

The REIT sector appears to be relatively stable. Looking at charts of the top 10 majors by market capitalization, you don’t see a recession in those charts. If there was a true downturn you’d expect to see depreciation in the major income trusts. I don’t see it, at least not yet.

Even when I exhaustively explore all the Canadian debentures that are publicly traded, I do not see anything that is compelling. The last debt investment which was glaringly undervalued was Pinetree Capital (TSX: PNP.DB) – but this was in February. They recently executed on another debt redemption which puts them on course to (barely) fulfilling their debt covenants provided they can squeeze more blood from their rock of a portfolio. I wouldn’t invest any further in them since most of what they have left is junk assets (Level 3 assets which will be very difficult to liquidate). One of those investments is a senior secured $3 million investment (12% coupon!) in notes of Keek (TSXV: KEK) which somehow managed to raise equity financing very recently.

The preferred share market has interesting elements to them as well. Although I’m looking for capital appreciation and not yield, it is odd how there are some issuers that are trading at compellingly low valuations – even when factoring in significant dividend cuts due to rate resets (linked to 5-year Government of Canada treasury bonds yielding 0.77%!). I wonder if Canada’s bond market will go negative yield like some countries in Europe have – if so, it means those rate reset preferred shares will have even further to decline!

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.