Divestor – Page 38 – Canadian Finance and Economics

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

Name	Root Ticker	MktCap 31-Jan-2020 ($M)	MktCap 27-Mar-2020 ($M)	Loss
Suncor Energy Inc.	SU	61,973	25,172	59.4%
Canadian Natural Resources Limited	CNQ	44,182	15,811	64.2%
Imperial Oil Limited	IMO	23,343	9,816	57.9%
Cenovus Energy Inc.	CVE	14,155	2,887	79.6%
Husky Energy Inc.	HSE	9,230	3,226	65.0%
Tourmaline Oil Corp.	TOU	3,617	2,116	41.5%
Vermilion Energy Inc.	VET	2,985	587	80.3%
ARC Resources Ltd.	ARX	2,486	1,335	46.3%
Crescent Point Energy Corp.	CPG	2,308	481	79.2%
Seven Generations Energy Ltd.	VII	2,222	488	78.0%
MEG Energy Corp.	MEG	2,024	365	82.0%
Whitecap Resources Inc.	WCP	1,974	387	80.4%

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!

Federal Reserve quantitative tightening – what my crystal ball says

The US Federal Reserve today announced they were going to raise the short term interest rate 0.5% and start their QT program on June 1st.

Because this was less drastic than the market was expecting, everything is rallying today because of continued easy monetary conditions, which will surely not help inflation expectations any.

My curiosity concerns the quantitative tightening, which proposes a $30 billion per month tapering starting June 1st, and then going to $60 billion per month on September 1st. This is on the treasury bond side, the mortgage backed security side has a different bucket of money to work with, but I will ignore mortgage backed securities in this post and just focus on treasury securities held by the federal reserve.

We look at what happened in 2017-2019 when the last attempt to do this occurred:

On January 3, 2018, the fed had $2.448 trillion in treasuries on the balance sheet. On January 2, 2019 they had $2.223 trillion, a taper rate of $18.75 billion per month.

The fed ended up crashing the stock market on the fourth quarter of 2018. It was a classic liquidity bust.

This upcoming taper will be faster ($30 billion a month), but it also comes from a much larger asset pool ($5.763 trillion). The taper doubles in September if they do not change things.

Compounding the problem is inflation. Back in 2018 the headline inflation was still very muted – talks of deflation were quite omnipresent. This time around, inflation is very much on the radar of everybody.

The federal reserve meets again on June 15 and July 27, where they have all but signaled rate increases (likely 50bps per meeting). This will still render the fed funds rate at a target of 1.75-2.00%, which by all historical standards is quite low, and especially considering the CPI at around 7%, still deeply negative.

My guess at present is that we are going to get a gigantic market rally in the next few months, especially in the stocks that have been taken out and shot over the past six months (looking at technology and software stocks in particular).

Shopify fans, you probably will be able to get some temporary revenge.

However, the will be temporary. While the rally in prices will be impressive, I do not think they will be sustained after the summer.

I am not a good enough trader to try this, but if I were to take a guess at where the speculative winds are blowing, I would long ARKK-type stocks for a couple months and then get rid of them sometime in August.

The TINA trade is breaking

Once upon a time, you had no choice – equities or nothing. This was referred to as TINA – there is no alternative. Bonds yielded you close to zero. (I’m rounding 0.2% to zero).

Today, two-year US government debt is now yielding 2.7%, which is still less than reported headline inflation, but at least it is something.

This is going to suck up liquidity from the market, and it is pretty obvious this has had a significant effect on broad market equities. Suddenly, instead of investing in bond-proxy equities like Microsoft or Apple, you can instead put the capital into everything-but-inflation risk-free government debt and earn your 2.7% yield this way. High-multiple stocks with promises to pay out in the distant future suddenly no longer look as good simply because there is an alternative.

We have a huge wall of worry ahead of us – the US Federal Reserve on May 5th will be raising interest rates and perhaps initiating quantitative tightening, we have China that is now making famous people in the white-bunny with blue stripe plastic suits enforcing Covid rules, we have the Russia/Ukraine dynamic and the threat of nuclear war, etc.

This is reflected in a high price for protection – the volatility index is once again has creeped upwards – paying for those put options is expensive!

With disaster always comes opportunity. I am sounding like a one-tune band, but those companies earning large near-term cash flows will be making their shareholders a fortune by the reinvestment in their own stock (assuming they have the liquidity to do so!). In some cases, the numbers appear to be extreme – if you could reinvest in yourself at 30% returns, would you? I sure as hell would. Some things are trading like as if everybody forgot how to read financial statements and perform the most cursory of forward projections.

In a rising rate environment, cash flow talks – ARCH’s payout phase

“How much should I pay for the equity” is an easy question to ask, but computing all of the variables to come up with a range of prices is not so easy.

One of the components is the rate of interest. As interest rates rise, you want your cash flows today instead of tomorrow.

For instance, if your high tech company will give out a billion dollars in cash 10 years from today, the rate of interest has a significant effect on today’s capitalized value.

At 1% your billion dollars of cash 10 years out translates into $905 million.

However, at 3%, that same billion dollars turns into $744 million, or about an 18% difference from the above.

This is one reason why long term government debt has been decimated as of late. For instance, the TLT ETF (with an average term to maturity of 26 years) from the local peak at the beginning of December to present has rendered investors a 21% loss. The higher the long-term yield goes, the more damage that gets priced into the capital value. This is only mildly tempered by the 2.47% coupon and 3.01% yield to maturity – in other words, all things being equal, you would have to wait 7 years to recover the loss.

The converse is true for entities that will give out cash today instead of tomorrow.

Arch Resources reported their first quarter results today. There is a lot of details to digest, but the obvious headline is the declaration of a $8.11/share dividend, which is the result of their capital allocation policy to give out half of their free cash flow in dividends, while retaining the other half for other general purposes.

With the price of coal, both metallurgical and thermal, being sky-high as a result of a huge confluence of events (chronic under-investment, ESG, Russia/Ukraine, Australia/China, and overall demand for steel production), Arch and other coal producers that are still able to produce (this is the key – they need to have functional mines and not promises to build them) are making a fortune in free cash flow.

This quarter alone, operating cash flow minus capex was $271 million. This number was smaller than it otherwise would have been due to logistical constraints on the railway that serves the company.

In Q2, this number will be increasing because they will be able to further restore rail capacity, coupled with the average realized price to likely be higher.

My rough estimate for Q2’s dividend will be about $11.60/share, but this depends on certain variables being achieved. Barring a complete and total collapse of the commodity market, it will be around that figure.

However, to be “conservative”, let’s use the previous number – $8.11/share. Multiple this by four times and you get $32.44/share annualized. At Monday’s closing price of $131.32, that represents a yield of 24.7%.

Realize that the dividend represents half of the free cash flow available to the company before a reclamation (asset retirement obligation) reserve.

Obviously the stock market is going to find a 24.7% annualized yield to be very difficult to resist, no matter how vilified the sector of the company is. Pension funds, with both broad exposure in an equity market that is down about 12% year to date and a long bond market that is down 16%, have gotten murdered this year. They need an avenue for returns. The temptation is going to be too much for them to avoid.

Not surprisingly the stock market has decided it was too much to resist and Arch is up about 20% as I write this post. The yield at the implied $32.44/year dividend is now down to 20%.

The question is how much temptation there will continue to be going forward. Will yields compress to 18%? 15%? 10%? This really depends on how desperate the market is for a return, coupled with their impression on how durable the coal market is.

At the current pricing of coal, however, Arch will pay back its entire enterprise value to investors (either through dividends or share buybacks) in a couple years. Needless to say, this beats Microsoft equity which has a total return of 4%, based off of analyst estimates on their upcoming fiscal year ended June 2023.

Going back to my original topic of interest rates and cash flows – in a rising rate environment, present cash flows talk bigger than the promise of cash in the future. Arch (and other fossil fuel companies) is going to be a demonstration why.

A happy problem is to decide how to re-invest the cash flows. Internally for Arch, after building up a sufficient cash reserve, they will likely engage in some sort of equity buyback which will further juice up the stock price. So they are already making part of the decision for you with their cash flow, although there is a diminishing returns aspect to this decision (inevitably they will buy back too many shares at too high a price, like they did in 2019). It doesn’t mean that you have to re-invest your dividend into them – indeed, it would probably be a better time than to be stockpiling the cash for stormier days.