First quarter review of oil and gas – and a look at Suncor

This is a brief review of the companies that have reported their quarterly results to date in the oil and gas space – specifically the ones in the Divestor Canadian Oil and Gas Index. (ARX, CNQ, CVE, MEG, SU, TOU, WCP have reported).

When your spot commodity exposure charts look like this, you know things are looking good:

The amount of bullishness out there in the previous week was a bit nuts and ripe for a correction. When markets ascend for this much time for this duration, there is a natural process where momentum and technical analysis players get cashed out, regardless of any fundamental underpinnings.

The financial market moves much, much, much faster than what goes on at a glacial pace in reality. While the amount that has evaporated out of my portfolio in the past week is impressive, it goes with the nature of finance that things will indeed be volatile, but the intrinsic value of the portfolio remains intact, reflected by real-world economics instead of financial economics.

All of the companies in the oil and gas index have been reporting record free cash flows, but most notably all of the players have been quite tight on growth capital in the sector – the free cash flow for the most part has gone into debt reduction, dividends and share buybacks. Now that most of these companies have reached their leverage targets, they are now continuing to deploy more cash into share buybacks, or (in the case of TOU) special dividends.

The financial mathematics of companies giving off sustained free cash flows (key word being ‘sustained’, noting that fossil fuel extraction is a cyclical industry) is interesting to analyze. I will use Suncor as an example.

Suncor guided in Q1 that their income tax payments will go up from the lower $2 billion range to $4 to $4.3 billion (note that income tax is a function of operating income minus interest expenses and after the removal of royalties, which is another huge layer of money given to the government!). Suncor does not have a material tax shield so they will be fully paying cash corporate income taxes. The Canada and Alberta corporate tax rate combined is 23%, and they have other operations in other provinces and overseas, so we will assume 23.5% as a base rate, which puts Suncor at $17.7 billion in pre-tax income ($13.5 billion after-tax).

Those with an accounting mindset will ask whether net income translates directly into free cash, and Suncor’s capital expenditures are roughly in line with depreciation. My own on-a-paper napkin free cash modelling also corresponds roughly to this $13.5 billion amount in the current commodity price environment.

Suncor has 1.413 billion shares outstanding as of May 6, 2022, so the upcoming year of income is $9.55/share. Suncor trades at $44/share as I write this, and has an indicated quarterly dividend of 47 cents per share ($1.88 annually). Although management has hinted this will go up over time, for now let us assume it is a static variable.

Deciding between debt reduction, dividends and share buybacks usually are a dilemma, but when the math is this skewed it is not.

Suncor’s debt currently costs them about 5.25%, or 4% after-tax. A share buyback not only alleviates the company from paying out the 4.27% dividend, but is also purchasing a 21.7% return on the equity.

This is a no-brainer decision from an optimization standpoint – every penny after regular capital expenditures, should go into a share buyback. The dividend should be brought to zero and shares should be bought back with that amount instead, until such a point where the return on equity goes below a particular threshold (my own personal threshold if I was calling the shots at management would be 12% or anything below $80/share in the current price environment!).

However, there are other variables to consider.

One is that the commodity price environment might not (and indeed is very unlikely to) last forever. There is a pretty good case to made that this particular price environment will last longer than most (instead of spending on capital expenditures like drunk sailors, companies across the grid are shockingly being very disciplined about limiting the amount of growth in production), and also the margin of error of the price level itself is quite high – West Texas Intermediate is at US$100 and even if it goes down to US$75, my models still have Suncor making around $8 billion in free cash. My $80 threshold price for share buybacks would drop to $47/share in this scenario – very close to the current market price.

So the argument to reduce debt is not out of financial optimization, but rather reducing the brittleness of the financial structure of the company. Hence the decision to allocate the residual 75% of free cash minus capital expenditures and dividends to debt reduction, and the other quarter to share buybacks. Although it is not financially optimal if you assume the current environment exists, it is a safe decision. They will do this until they go to under a $12 billion net debt position, which will happen at the end of Q3/beginning of Q4. (Note that Suncor introduced a new conservative fudge factor by adding in lease liabilities into this definition which inflates the net debt number).

After they reach the $12 billion net debt figure, then 50% gets allocated to debt and 50% to the share buyback. At the current commodity environment and share price, they will be able to complete nearly the 10% full buyback with this regime. After they get down to $9 billion in net debt, then the debt reduction goes to 25% and share buyback will go to 75%. I just hope that management has the prudence to taper the buyback and increase the dividend if their share price gets too high.

The other variable is the dividend. While the tax inefficiency of dividends are well documented elsewhere, it does provide a “bird in the hand” component to the stock, and also gives the buyback itself some metric to be measured against. While other people consider a dividend to be very important, I am agnostic about a particular dividend level, except in context of alternatives.

Obviously if a company has capital investment opportunities, you do not want to see a dividend. You instead want to see them deploying this capital in productive ventures. However, in the fossil fuel industry, there is a very good argument to be made to just keep things as-is and just go on cruise control – this is exactly what is happening for all of these companies. They are paying down debt and allocating cash to dividend and share buybacks, especially when all of them are giving out 20%+ returns. There is no reason not to.

The ultimate irony here is that in such an environment where cash flows are being sustained, it works incredibly in the favour of investors that the market value of these companies remains as low as possible, to facilitate the execution of cheap share buybacks.

This leads me to my next point, which is that it does not take a CFA to realize that on paper, many of these oil and gas companies are perfect candidates for leveraged buyouts. Only the perceived toxicity of fossil fuels and ESG has prevented this to date, and I am wondering which institution will be making the first step in outright trying to convert a leveraged loan (even in the elevated interest rate environment, they can get cheap debt) to buy out a 25% cash flowing entity. It is inevitable at the current depressed market prices.

The first warning shot on this matter (which is cleverly disguised as a strategic performance improvement scheme) comes from Elliott Investment Management’s Restore Suncor slide deck. They can’t outright say what they’re thinking – let’s LBO the whole $60 billion (market value) firm!

Needless to say, an investor in this space makes most of their money “going to the movies”, as Warren Buffett said about one of his earlier investment mistakes (selling a company too early). I think this will be the case for most of the Canadian oil and gas complex.

What, stocks can go down too??

The jaw-boning of the central banks (every word out of the Bank of Canada and Federal Reserve are both to the tone of interest rates to rise forever) have finally had their desired impact – a suppression of demand in the asset markets, which will likely transmit itself to the overall economy, lessening inflation rates.

They’ll probably shut their mouths at some point in time when enough damage has been done. This is reminding me of the trading that occurred during the year 2000 in the Nasdaq – an incredibly volatile year, and the Federal Reserve at that time had the issue of how to withdraw its liquidity stimulus that it pumped into the market in 1999 (remember Y2K?).

Most of the technology starlings, including Shopify (TSX: SHOP), and the like are all sharply down over the past half-year. Psychologically speaking, for those that have held the stock anytime from April 2020 to today, they are now underwater. For those that bought in 2021, they are down roughly 75% on average. How much pain can they take before cutting out?

This is the challenge of investing in companies with projected cash flows in the far future – with Shopify, you have to take a shot in the dark as to when you’ll actually achieve a return on investment (i.e. the company generates positive cash flows which can be subsequently distributed to investors):

This re-rating of Shopify’s future non-earnings, coupled with the speculatively suppression of higher interest rates, clearly has had a very negative effect.

I am just picking on Shopify because it is Canadian, but this is also exhibited by all sorts of other technology darlings of the past. Today, for example, Palantir (PLTR) has been hammered 20%, on the basis of a very tepid quarterly earnings report (which more or less reported a break-even quarter which had all sorts of ‘adjustments’ to claim a positive free cash flow balance).

Don’t get me started on the effect of rising interest rates on cryptocurrency, where you’re going to have every investor on the planet realize that Bitcoin has a carrying cost (why hold onto BTC for zero yield when you can give your money to the Bank of Canada for a year and get 2.5% out of it for nothing?). You don’t hear too much about the scarcity of available Bitcoins these days! We’ll see if Michael Saylor at Microstrategy (MSTR) is forced to liquidate his stack of 129,218 Bitcoins and if so, that will be the margin call of the year for sure. One look at MSTR’s balance sheet and you do not need to be a Ph.D in corporate finance to figure out that his leverage situation is even more precarious than Elon Musk’s reliance on Tesla stock being sky-high.

In these environments, however, the best cliche used to describe things is that babies get thrown out with the bathwater. There are companies out there in the technology field which get lumped in with all of the ETF selling (go look at the holdings of ARKK here!) that do have value (beyond the obvious such as the Microsofts of the planet which will continue to have vast earnings potential due to their wide moats).

However, current free cash flows speak volumes. Companies trading under 5 times free cash flows are going to make mints for their shareholders by continued purchases of their own equity, and for those companies generating cash, shareholders should be cheering for continued lowering prices to generate excess future returns. Those that have prudently managed their balance sheets will be in a much better position to be opportunistic.

Finally, a word for those thinking that commodity investing is a one-way ride – in markets, nothing ever is! Yes, this includes Toronto residential real estate. There has been a lot of what I call ‘energy tourists’ and they have latched onto many of these stocks during earnings time (fossil fuel companies in Q1 have reported insane amounts of profits). There is an urge by many to over-trade and to shift portfolios away from quality into more speculative names (various < 50,000 boe/d with operations of more questionable characteristics) in order to torque up their return profiles. In a rising market, it is the lower quality companies that tend to exhibit the higher percentage gains, while in a flat or declining market, it is the quality firms that will have the sticking power. Stick with quality. It will let you sleep better at night in times like these, much more so than a pre-build contract for a 450 square foot Toronto condominium.

Bank of Canada – Quick macro look

At the close of the week, the 10 year Government of Canada bond yield reached 3.07%, which is the highest it has been since May 2011!

Going 10 more years back in time, it got up to 6% in 2001. How high yields will go, who knows……

My other comment is regarding the first phase of quantitative tightening. On May 1, the first slab of Bank of Canada-held government debt ($12.6 billion) matured and this is the impact it had on the balance sheet of the Bank of Canada:

Note that individual tax return payments were due to the government of Canada by April 30, hence the increase in its deposit balance with the Bank of Canada. However, the important figure is the $200 billion held in reserve by “Members of Payments Canada” (i.e. the big banks) which is declining. Upcoming maturities are $3.1 billion in June and $16.8 billion in August.

Capital is on its way to becoming an expensive resource once again. Position accordingly.

A trip down memory lane – Canadian Oil and Gas AND the institutional pension fund manager dilemma

What’s left of Canadian oil?” – March 29, 2020:

27-Mar-2020: TSX Oil Producers

NameRoot
Ticker
MktCap 31-Jan-2020 ($M)MktCap 27-Mar-2020 ($M)Loss
Suncor Energy Inc.SU61,97325,17259.4%
Canadian Natural Resources LimitedCNQ44,18215,81164.2%
Imperial Oil LimitedIMO23,3439,81657.9%
Cenovus Energy Inc.CVE14,1552,88779.6%
Husky Energy Inc.HSE9,2303,22665.0%
Tourmaline Oil Corp.TOU3,6172,11641.5%
Vermilion Energy Inc.VET2,98558780.3%
ARC Resources Ltd.ARX2,4861,33546.3%
Crescent Point Energy Corp.CPG2,30848179.2%
Seven Generations Energy Ltd.VII2,22248878.0%
MEG Energy Corp.MEG2,02436582.0%
Whitecap Resources Inc.WCP1,97438780.4%

On January 31, 2020 there were 12 companies trading at a market cap of above $1 billion in the space (I removed the non-Canadian ones trading on the TSX). At the end of March 2022, there are about 28 of them.

CNQ is now the top dog with nearly a $100 billion market cap.

CVE bought HSE and is now sitting at around $50 billion.

How things have turned.

The even more interesting factoid is that when looking at CNQ’s quarterly earnings report, they have gone painfully out of their way to avoid telling people how much money they will be making.

The entire complex is trading as if the commodity environment is a ‘transient’ event. As a result, we are seeing very low free cash multiples to enterprise value.

This creates two avenues to earning a return.

One is that you sit on your rear end and wait for these firms to buy back their stock and/or give out dividends and you will earn a return the old-fashioned way – by buying and holding.

The other way is through speculation that the fossil fuel price environment is here to stay for a lot longer than most expect – you will then be a happy recipient of a multiple expansion.

Unlike a technology company stock that promises to pay out a decade from now after making copious amounts of expenditures, most (if not all) of the fossil fuel producers are generating cash today.

What is even more interesting is putting your mindset into the perspective of a pension fund manager.

You have a mandate to earn a return of, say, 7% for your clients. I’m ignoring the fact that CPI has skyrocketed this year (which would inevitably push up this number for the cost of living allowances that are typically given out with defined benefit plans, including the CPP).

On a day like today, both the overall equity market AND the long-term bond market have dropped. Normally there is an inverse correlation between the two assets. This correlation appears to be breaking.

If your pension plan is forbidden from investing in fossil fuels for whatever reasons, the pension managers have to achieve their returns in the rest of the market that does not include fossil fuels.

This is an exaggeration, but it is the financial equivalent of trying to earn a 7% net return on the residential condominium market in Toronto (or Vancouver, take your pick).

Formerly you were able to do it with leverage (e.g. take a 4% gross return and turn it into 7% by borrowing a bunch of money at 2%), but today, you can’t do this in a rising rate environment. Rising interest rates increase the cost of carrying debt, and hence why you are seeing liquidations.

Likewise in the equity and bond markets, the leverage trade appears to be unwinding. Central banks have given fair warning rates are increasing. Unlike in 2017 when rates rose again and inflation was very low, today’s environment has inflation figures that have not been seen since the early 80s.

Physical cash held by Canadians

This is a misleading article.

Globe and Mail article: Canadians are sitting on record amounts of cash – but nobody is sure what to do with the money

More than two years into the pandemic, Canadians’ wallets are still stuffed with cash.

There is currently about $113-billion worth of physical money in circulation in Canada, up by nearly 25 per cent from pre-pandemic levels. As a share of the overall economy, that’s more cash floating around than at any time since the early 1960s.

One problem with this article is that the amount of physical cash has continually been increasing since 1990, but during Covid-19, the rate of growth has accelerated, but not to a ridiculous degree:

This number has increased by around $25 billion during the Covid panic (measured from March 2020). A more “ambient” year-to-year change is around $7-8 billion in supply, which means that about $10 billion in cash was created as a result of the Covid panic. A large amount of money, yes, but nothing compared to the overall monetary base.

What the article should be focused on is the creation of credit during Covid-19, and you can view some evidence of this by examining the monetary aggregates as compiled by the Bank of Canada (I suggest looking at the unadjusted M2++). Needless to say, in our formerly zero-interest rate environment, credit creation has skyrocketed!