Divestor’s Canadian Oil and Gas Index

This post is for future reference.

In general, the status of Canadian oil and gas (no doubt due to ESG investors, coupled with our federal administration) has suppressed asset prices to the point that is reminding me of how Philip Morris was trading in 1999-2000 (single digit free cash flow multiples). Needless to say, I think we are in the early stages of a mean reversion process.

I introduce Divestor’s Canadian Oil and Gas Index (DCOGI), which covers a good swash of upstream production, and some downstream as well. It is a pretty simple index which covers most of the Canadian oil and gas production, and some downstream refining –

20% of: CVE, CNQ, SU
10% of: TOU, WCP
5% of: ARX, BIR, MEG, PEY

I will set the index at 100, and construct it off of a notional index of $1M invested at the prices closing February 5, 2021. No rebalancing. Dividends/distributions will NOT be reinvested but cash drag will be tracked. I’ll post more details of the index composition this weekend and track it periodically.

(Update, December 14, 2021 – I have posted a Re-Balancing Policy)

Update at the end of the trading day:
Ticker – Shares:
ARX – 7,426
BIR – 20,325
CNQ – 6,196
CVE – 24,600
MEG – 8,993
PEY – 10,482
SU – 9,066
TOU – 4,662
WCP – 19,048

The index performance can be viewed here!

The most profitable industry on the planet

At this time, the most profitable industry has to be mortgage insurance in Canadian real estate markets.

Genworth MI (TSX: MIC) reported Q4 earnings.

The loss ratio reported was 10%. The expense ratio was 21%.

This means out of every dollar recognized in revenues leads to 69 cents of pre-tax profit.

Needless to say, this is a gigantic amount of economic extraction from an industry that is somewhat protected (by virtue of the federal government taking the mountain’s share of profits through CMHC).

It is funny how the public hasn’t connected the dots on how this makes borrowing with large-ratio mortgages extremely expensive – a 10% down mortgage can incur a 3.1% mortgage insurance fee. While 3.1% may not intuitively seem expensive, it is a huge fee considering that the bulk of the risk of default in a mortgage occurs in the first 5 years (where in a typical 25 year amortization, about 15% of the loan is amortized) while the rest of the time period is generally “home free” for the loan provider. This effectively results in a 60bps accretion to a loan’s profitability (compare that to a bank that makes less spread than that on the mortgage loan itself!).

Brookfield is in the very late stages of taking MIC into its fold at CAD$43.50/share. At the rate they reported net income in 2020, that works out to about 8.5 times earnings.

Normally industries with such large profit margins attract competition. The barrier to entry is access to the Government of Canada guarantee (CMHC gives a 100% guarantee, backed by the Crown, while MIC is 90% guaranteed by the Crown, with the residual guaranteed by their shareholders), and access to the mortgage networks (which can give approvals based off of customer profiles). Not an easy industry to crack for a new entrant, and the only real basis of competition would be price.

Enbridge Line 5 and pipeline politics

It is going to be very interesting to see what happens with Enbridge and Line 5.

The reason why the Federal Government cares about keeping Line 5 operational is because it processes about half of the crude oil that is refined for southern Ontario and Quebec. You can take a car to Sarnia and see the refineries.

A shutdown of Line 5 would, needless to say, be very disruptive for the region. There isn’t a good way to get additional capacity into the area – the other routes are fully utilized.

The federal government only cares about what is good for, roughly, the traditional boundaries of Upper and Lower Canada. Any policies that are tailored for areas away from this geography is strictly coincidental.

Thus, the Keystone XL cancellation was of little concern to Ottawa. The usual lip service of condemnation by politicians, when it is so obvious they don’t mean it.

I am still somewhat mystified today that the federal government bought out the Transmountain pipeline project – most people do not know that there is an existing (profitable) pipeline in place. Its existence does not matter an iota to Ottawa.

Line 5, however, is different. It fuels Ottawa’s core geography.

It was not longer than a decade ago when this strategic and political vulnerability was identified and hence the Energy East project was conceived. After the Liberals got into office in October 2015, they proceeded to kill the project with a never-ending wall of regulation.

We fast forward today and see where such lack of strategic thinking is par for the course in Canada.

It is not my job to moralize about the inadequacies of government thinking, but rather to pick out winners and losers.

I am still puzzled why so many people are in love with Enbridge as being a staple in their yield portfolios. There is far more risk than they imagined.

The sentiment will change when there is a real connection between very poor decisions and actual hardship experienced by people. The lag between the two, however, could take many, many years and attribution of blame may be misdirected.

Likewise, few lament over how much richer we could have all been, collectively as a society, had we had our act together to begin with.

Politicians, however, are not rewarded for making optimal or efficient decisions. In fact, they have a gigantic incentive to not solve problems, lest their purpose of existence be threatened.

Dorel’s going private takeover bid increased

Dorel (TSX: DII.B) was in the process of going private. Their previous bid had been CAD$14.50, but today they announced this will rise to CAD$16.00.

This post is not to discuss the valuation of the offers, but to highlight a trend of increased bids:

Rocky Mountain Equipment: CAD$7.00 -> CAD$7.41
Great Canadian Gaming: CAD$39.00 -> CAD$45.00
Dorel: CAD$14.50 -> CAD$16.00

Dorel’s bid was already somewhat anticipated by the market, where at around Christmas they started to trade over the CAD$14.50 threshold:

One can have hope for Atlantic Power, but I’m not holding my breath!

How much to pay for yield?

Some near-guarantees of interest income, how much will people pay for it? This is typically represented in a “yield to maturity” calculation but here is another way of looking at things which may be a little more intuitive – it involves capitalizing the cash stream to be received to the present, with a zero discount rate. It is a fun exercise:

* Bombardier 8.75% December 1, 2021 unsecured debt, not callable: Trading at bid/ask 104.35 / 105.65. Bombardier has completed their disposition of their transportation division with Alstrom, and has indicated they are exploring how to manage their debt. This one is the nearest term maturity and is a lock to mature. As there is 10 months left to maturity, the remaining coupon is worth 7.3% of par, so at the midpoint, an investor would be paying 105% to receive 107.3% over 10 months.

* Yellow Pages (TSX: YPG.DB) 8%, stated maturity November 30, 2022 but callable at par, May 31, 2021. Trading at bid/ask 101.2 / 102.4. Management has stated for the past few quarters they will be redeeming this debt as soon as they can. With 4 months of interest remaining, that is 2.7%. There is a tiny, tiny amount of optionality in the potential conversion (they can be converted into stock at $19.04/share but that is 55% above the current trading price and not too probable, although one quarterly report showing revenue stabilization would alter that conclusion).

We also have some “zero-coupon” equivalents in the form of merger arbitrage.

* Atlantic Power (TSX: ATP) will be bought out for at least US$3.03 in the second quarter. Right now, trading at US$2.96, that is +2.4% over an estimated 3-5 months (more attractive than the bonds presented above, in addition to the gain being on capital and not income account!). The risk of merger arbitrage, of course, is that the deal will fall through.

The baseline for cash is the high interest savings ETF (TSX: PSA) which gives out a yield of about 50 basis points at present. There’s almost no point in investing in this ETF at present, but they have a whopping 2.4 billion in AUM, skimming off 15bps of MER, so good for them.

The above are examples that will yield superior returns than the risk-free option. Indeed, there are plenty of options to skim a few hundred basis points of yield for very little risk, but it involves work and paying attention. It does come at the cost, however, of liquidity.