Canadian housing stats vs. Mortgage Insurance

Genworth MI (TSX: MIC) has taken a hit over the past three weeks due to statistics that housing sales and average prices are declining nationally, according to a CREA report. Another sensationalist headline (“Canada’s average home price drops over 10% year-over-year in March”) is here.

Genworth MI stock rose in the month of March partially due to the company going on a buying spree on a stock buyback – it bought back 1.2 million shares. Other than that, there has been consistent selling pressure.

The report cites the impact of the B-20 regulation from OFSI, which increases the qualification criteria for people to obtain non-insured residential mortgages.

There are two factors here as it relates to Genworth MI that are being confused: 1) the pool of potential insurable mortgages, 2) what exactly the implication of average pricing statistics entails.

Aggregate Statistics

What market participants are failing to understand is that statistical averages fail to capture the economics of the mortgage insurance market, even in a declining average price environment and are probably taking down the stock due to incorrect reasoning (which usually leads to an environment where the stock will be undervalued).

The national housing price statistics are dominated by three regions: Toronto, Montreal and Vancouver. The “right-side tail” of the distribution of housing prices in the Toronto and Vancouver markets (especially in single-family residential) are dominant factors in statistical mean pricing. For instance, if your housing market consisted of a $3 million house, a $1 million townhouse and a $500,000 condominium, a 10% decrease in the house price would dominate over a proportionate decrease in the townhouse or condominium price, due to price weighting.

Vancouver is an extreme market, partially due to the huge influx of foreign capital buyers, which the government is actively trying to curtail. The 95th percentile of the real estate market is dominated with speculation from foreign (mainly people connected to Mainland China) buyers and asking prices have been decreasing in the hundreds of thousands of dollars for single family dwellings in the Metro Vancouver region. I have been paying less attention to the Greater Toronto Area, but apparently there is a similar mechanic going on there.

As a result, when speculation moves the 95th percentile market, it will result in massive price swings that have powerful effects on aggregate mean statistics. There is a “bubble-down” effect on the remainder of the real estate market, but this is more diffuse and domestic demand for lesser priced properties serves as a buffering effect for the absolute decline (not percentage decline) in those prices. It pays to longitudinally study properties that are in the 50th percentile (i.e. using median statistics) as a more intuitively accurate grasp of what is going on. These usually aren’t published.

Mortgage Insurance Eligibility

Keep in mind that properties over $1,000,000 are not eligible for mortgage insurance. Secondary residences in Vancouver, Calgary and Toronto are up to $750,000. (Good luck with this amount in Vancouver!).

Net Impact to Genworth MI

The only impact I would expect from what is happening in Vancouver and Toronto is that less mortgage insurance will be written – this is derived from the decrease in re-sales of real estate. The quality of the underlying insurance portfolio will also exhibit a higher loan-to-value ratio as prices normalize, but as mortgage insurance services the more “retail” element of real estate purchasers, I would expect them to continue paying their mortgages and amortize the existing debt amounts – 15% of the debt is amortized in 5 years with a typical 25 year amortization period and 3% interest rate. Employment is a much bigger driver – I would worry if unemployment rises.

Genworth MI will report the first quarterly report in late April or early May – I would continue to expect to see very good numbers posted with respect to loss and severity. Book value should also creep up another 60-70 cents per share, which would bring it close (but not quite) to $44. At the current price of $39, they are trading at a moderate discount.

What if Alberta shut down the Trans-Mountain Pipeline?

There are media rumblings that Alberta will be shutting off the flow of oil to British Columbia on the Trans-Mountain Pipeline (TSX: KML) with the enactment of Bill 12. Right now the Bill is sitting on the notice paper of the Alberta legislature so we do not know precisely what the content of the Bill says.

Enactment of Bill 12 (or at least one that would cut off the pipeline) would not happen for a variety of reasons – one is that Kinder Morgan is contractually bound to deliver oil, and an act of the legislature stopping this would mean that Kinder Morgan could make a civil claim for damages. At the very least the Government of Alberta would be civilly liable for such an action. It would also likely be deemed to be against the Canadian Charter.

But let’s run a thought experiment and pretend that for whatever reason it actually happened. The media report states that one of the consequences would be that the price of gasoline would rise above $2/litre.

I would claim that gas prices would go much higher than this – my paper napkin estimate would be a free market price closer to $5 per litre after a month of pipeline shutdown. It is at this price range that there would be a material amount of price elasticity in terms of decreasing gasoline consumption. In addition, it is quite likely that YVR airport would have to significantly curtail a material amount of flight activity as there would be an insufficient supply of aviation fuel. I would view it as probable that a prolonged period that Trans-Mountain was inactive would cause a severe logistical constraint on the cost of transportation and the subsequent cost structure would result in significantly increased costs for transportation services (e.g. bus and cargo logistics).

The rationale for this: The Vancouver, BC area used to have 4 oil refineries but three of them have shut down in the mid 90’s. The sole remaining refinery is the Chevron Burnaby refinery (now owned by Parkland Fuel (TSX: PKI) but will refer to them as Chevron for the remainder of this post), which processes about 55,000 barrels of oil a day. A barrel of crude oil (roughly 159 litres) can be refined into ordinary unleaded gasoline, diesel, kerosene (aviation fuel), paraffins, etc. Very roughly for dilbit (and this depends on what comes in), you can get around 40% to gasoline, 30% goes to diesel/jet fuel, 10% liquid gas, 10% fuel oils, and 10% other.

The Chevon refinery receives most of its crude oil (feedstock) via three routes: tanker (barge), rail, pipeline. By curtailing the pipeline, there would have to be increased traffic on other transportation modes. Chevon has a 3 day supply of feedstock.

Metro Vancouver (Greater Vancouver Regional District – extending from Bowen Island, Lion’s Bay and West Vancouver eastwards to Maple Ridge and Langley) pays 17 cents per litre of gas taxes to Translink on regular gasoline and clear diesel. Translink is on track to earn about $380 million this year from gasoline taxes, which works out to roughly 38,000 barrels of gasoline a day for the region. This does not include gasoline sold in Abbotsford and Chilliwack, which is fed from Metro Vancouver and would contribute another 10% of gasoline consumption (assuming a proportionate consumption to population).

This also does not assume that any “border leakage” of taxation occurs. It is second nature to a lot of people that live close to the border to go down to Blaine, WA or Bellingham, WA to save on gasoline – prices are CAD$0.35-$0.50/litre cheaper. We will assume that this does not occur in a material manner (one estimate is 1-2% of consumption).

Putting aside this assumption, this means roughly 42,000 barrels/day of Chevon capacity is used for gasoline consumption, which would infer that the refining capacity at Chevon is just about at its maximum limit. There is another Chevron terminal which deals strictly with refined product (65% motor fuel and 35% diesel) that imports another 8 million barrels/year of product (22,000 barrels/day). It is not entirely clear to me how much of this is “external” and how much of this is from the Chevron refinery.

We have not included the consumption effects of the YVR airport. The airport consumes approximately 5 million litres of jet fuel each day, which is another 31,000 barrels per day. Its primary source for this fuel is from a Kinder Morgan Pipeline (despite all the attention that Trans-Mountain gets, this Kinder Morgan pipeline extends underneath most of the residential area of Vancouver within incident) – but due to insufficient capacity on this pipeline, YVR has to import approximately 20% of its refined jet fuel product from Cherry Point, WA.

The residual jet fuel from Cherry Point to YVR is carried by tanker truck, approximately 30 each day. This is the most expensive and inefficient form of transportation (in relation to pipeline, tankers and rail).

In Washington State, there are two major crude refining facilities which receive their crude oil feedstock via tankers from Alaska (another irony of Canada’s “tanker-free” Pacific policy) – the closest refineries are at Cherry Point and Ferndale. Cherry Point has a refining capacity of 225,000 barrels/day and the Ferndale refinery is about 100,000 barrels/day.

If the BC Chevon refinery was starved from its crude oil feedstock from pipeline, there would be an immediate shortfall of refined fuel product at current levels of consumption. Needless to say, it would not matter at this point how many tanker trucks you tried to bring over the border or how much you tried to feed the Chevron terminal, it would not come close to the amount of domestic consumption – there would not be enough tanker trucks available, and Cherry Point would not be able to economically supply that amount of refined product on short notice as has other customer commitments in-state.

There is a pipeline that connects Cherry Point to Sumas, but the logistics of converting this into a refined product pipeline is not clear to me. Either way, this would not be easy to pull in on short demand.

At this point there would likely be severe rationing of fuel stocks and I would suspect that in a short period of time (within about a week of being starved from crude from Trans-Mountain) pricing would go much, much higher than the $2/litre estimated by the media report. In addition, YVR airport operations would likely be impacted. Needless to say, the economic disruption would be massive and at this point it should be completely self-evident how important the pipeline and the domestic refinery is for the Metro Vancouver economy.

OPINION: The Metro Vancouver public consciousness of the importance of the crude oil pipeline would likely be extremely amplified by a shutdown of the Trans-Mountain Pipeline. It is probably one reason why the NDP government in Alberta is considering this action, even though they would know it would come with huge future consequences in the form of an adverse court verdict – one that they are happy to deal with after their next election.

Indexing Illusions

Article: This $100 Billion Fund Manager Says Canadian Stocks Are About to Bounce.

The argument is that because the TSX has underperformed the S&P 500, there will be a regression to the mean that will have the TSX align to the S&P 500 (or vice versa).

This article implies that over-weighting the TSX and under-weighting the S&P 500 would outperform an even-weighting of both indicies.

I’m not predicting the future of each index, but the relevant variable to consider is that the top two sectors of the TSX currently are roughly 35% financials (think the big banks, insurance, etc.) and 20% energy, while the top two sectors of the S&P 500 are roughly 24% IT (think about the FAANGs – Facebook, Amazon, Apple, Netflix, Google, etc.) and 15% financials.

Very roughly speaking, if you think financials and energy will do better, invest in the TSX. If you believe in the FAANGs and want a flatter distribution of sectors, invest in the S&P 500. (Intuitively, it would appear to me that if you bought the S&P 500 and shorted the high P/E components such as Facebook, Amazon, Netflix, Google, and others such as Tesla, you’d probably have a comparable value index – I’m sure some quants out there have already done this simple work years ago).

An index always consists of components that can be individually analyzed. Conventional financial literature suggests that an index somehow is better than investing in components, but the only inherent benefit of this is the risk-reduction power of diversification rather than any basis in valuation.

Another bullet shot in the heart of Canadian oil production – Kinder Morgan

Paying attention to Kinder Morgan’s (Parent: NYSE: KMI, daughter: TSX: KML) announcement that they’re stopping non-essential expenditures in relation to the Trans-Mountain pipeline (that goes roughly between Edmonton, Alberta to Burnaby, BC) expansion.

There’s a lot of political rumblings and a ton of public ignorance displayed, which usually is a good recipe for market reactions that lead to opportunity.

KMI owns 70% of KML. KML owns the assets relating to the Trans-Mountain pipeline. The assets currently pump about 300,000 barrels per day and very roughly, in 2017 produced $250 million in operating cash flow (allow me to ignore the very relevant capital expenditures in this post – they spent $618 million, the majority of which was on the Trans-Mountain expansion project – $445 million on pipelines and $173 million on terminals).

There are about 350 million shares outstanding in KML, so the most elementary analysis possible is that if KML decided to pack up shop and just keep the existing (and aging) infrastructure in place, they will generate about 65 cents of cash for shareholders – this is subtracting the amount given to preferred shareholders. Other than the preferred shares and pension liabilities, there are no other material amounts of debt or obligations on the balance sheet that is noteworthy for this analysis.

Obviously this amount would not be enough to sustain the existing stock price – currently CAD$18.44/share – the earnings yield would be around 3.5%, although this would be a very stable yield given that this is the only oil pipeline connecting the west coast of Canada to oil-rich Alberta. The expansion project is expected to bring in $900 million in EBITDA in the first 12 months of operations, plus spot volumes up to another $200 million. Since the project is expected to cost around $7 billion, a financing at 5% would still result in substantial after-tax cash flows.

A tripling of the pipeline capacity will, suffice to say, be extremely profitable for Kinder Morgan. Strategically speaking, the asset is the only oil-carrying pipeline from Alberta to Vancouver (good pipeline map resource here). Vancouver’s sole oil refinery is the Chevron facility, west of SFU. The nearest competitor is refined fuel product from Cherry Point, WA, which makes Vancouver extremely vulnerable to any slowdown/shutdowns in both oil capacity and refining capacity.

Politically speaking, there are a set of huge competing interests at play:
– The federal Liberal government attempted to play a “middle ground” by supporting the pipeline, but they are dragging their feet on doing anything to getting it approved, and one can infer from Bill C-69 that the government intends to create so much regulatory uncertainty in the approval of any major national projects that they simply are not going to be built. Bill C-69 makes it impossible to know what conditions (and thus costs) it will take to approve projects requiring federal environmental assessment (soon to named “impact assessment”) approval. The Liberal government probably realizes at this point there is zero vote-getting ability for them to support the Trans-Mountain expansion, so they will only give lip service toward its approval – and lip service so they can avoid being seen as flip-flopping.
– The Alberta Government, led by NDP Premier Rachel Notley, has a huge economic interest in the pipeline. While inherently most of the people in her party are against pipelines in general, a lot of Alberta’s economy depends on the fortunes of the oil industry and if the NDP are going to have any chance of being re-elected, they need to galvanize the feelings of voters that they (and not UCP leader Jason Kenney) are best to fight Ottawa and British Columbia.
– The BC Government, led by NDP Premier John Horgan, is fighting on a side which inherently favours them. They attempted to enact some provincial regulatory reforms to make it more difficult for the pipeline to proceed, and they can do this because they have the support of their party and also the 3 Green Party MLAs that are strongly against the pipeline (the government is a narrow minority government that requires the support of the 3 Green Party MLAs in order to maintain supply). They have everything to gain by combating Alberta and Ottawa and only a modest amount to lose as not too many NDP supports would support the economic-creation aspects of pipeline construction. In addition, the majority of gains to be made if the pipeline expansion is completed is Albertan oil companies, so this does not favour BC. The BC Government will likely do anything it can to stall the project and will only yield way if required to do so by court judgement – that will be their “out” to explain to the public that they tried.

It appears pretty obvious to me that the current Nash Equilibrium is the pipeline expansion will be indefinitely stalled. It will probably take a Supreme Court ruling to unlock the situation and one is not forthcoming due to the Federal government intentionally deciding to not participating in a planned BC-Alberta reference case – lest the reference (info) definitively decide the matter (which works against the three governments’ existing interests).