Divestor – Page 182 – Canadian Finance and Economics

A few bargains – Oil and Gas

I’ve been examining the wreckage of the market carnage over the past few days (these types of high volatility situations tend to create opportunities) and in general I have not been too impressed with what I have seen. Either that, or what I have been examining has been unfruitful material.

The big exception: the oil and gas sector.

The reason why they have cratered is because of this chart:

Then I start scouring the list of TSX oil and gas sector companies that are over a market capitalization of a billion dollars. The TSX maintains a comprehensive list of listed companies which I find to be of surprising value when I look for quick lists of companies. I generally don’t tread below a billion in capitalization for resource firms since companies of that capitalization are dominated by insider information where a good drilling result will make the difference between life and death and the last person to get this information will be the outside public.

Larger capitalization companies also receive the benefit of financial economies of scale as they will be able to raise capital in meaningful amounts at lower costs – just imagine if you were a bank lending to a $10 million microcap exploration company versus lending to Suncor – a world of difference.

I also exclude anything international (e.g. CNOOC) as my comfort level with companies with international operations (outside Canada/USA) is quite low. There are some Canadian companies with international operations (e.g. Husky) but I have not excluded them from the list.

This leaves the following:

Name	Root Ticker	QMV(C$) 31-August-2014	O/S Shares 31-August-2014	Price Aug 31	Price Oct 17	Diff
Suncor Energy Inc.	SU	65,392,529,963	1,465,214,653	$44.63	$37.43	-16.1%
Canadian Natural Resources Limited	CNQ	51,752,147,469	1,092,047,847	$47.39	$38.64	-18.5%
Imperial Oil Limited	IMO	49,042,078,776	847,599,011	$57.86	$51.56	-10.9%
Husky Energy Inc.	HSE	32,835,380,634	995,641,711	$32.98	$27.89	-15.4%
Cenovus Energy Inc	CVE	26,251,047,328	756,950,615	$34.68	$26.44	-23.8%
Crescent Point Energy Corp.	CPG	19,054,037,160	423,423,048	$45.00	$37.80	-16.0%
Encana Corporation	ECA	18,575,904,053	740,961,470	$25.07	$20.99	-16.3%
Talisman Energy Inc.	TLM	11,519,723,579	1,044,205,268	$11.03	$7.41	-32.8%
Canadian Oil Sands Limited	COS	11,349,573,179	484,610,298	$23.42	$17.97	-23.3%
Tourmaline Oil Corp.	TOU	11,093,225,024	201,438,624	$55.07	$46.15	-16.2%
ARC Resources Ltd.	ARX	9,961,515,096	316,942,892	$31.43	$28.70	-8.7%
MEG Energy Corp	MEG	8,663,315,635	223,684,886	$38.73	$29.03	-25.0%
Baytex Energy Corp.	BTE	8,074,310,078	166,069,726	$48.62	$36.10	-25.8%
Vermilion Energy Inc.	VET	7,547,863,325	106,713,747	$70.73	$64.36	-9.0%
Paramount Resources Ltd.	POU	6,310,684,139	104,654,795	$60.30	$51.77	-14.1%
Peyto Exploration & Development Corp.	PEY	5,921,706,832	153,690,808	$38.53	$34.20	-11.2%
PrairieSky Royalty Ltd.	PSK	5,135,000,000	130,000,000	$39.50	$34.00	-13.9%
Enerplus Corporation	ERF	5,108,169,000	205,229,771	$24.89	$17.15	-31.1%
Whitecap Resources Inc.	WCP	4,521,895,736	245,621,713	$18.41	$14.98	-18.6%
Penn West Petroleum Ltd.	PWT	4,182,765,734	495,001,862	$8.45	$5.51	-34.8%
Pengrowth Energy Corporation	PGF	3,938,186,665	531,408,321	$7.41	$4.90	-33.9%
Athabasca Oil Corporation	ATH	3,181,210,140	401,667,947	$7.92	$4.46	-43.7%
Trilogy Energy Corp	TET	3,034,453,657	105,071,110	$28.88	$20.80	-28.0%
Bonavista Energy Corporation	BNP	2,991,583,651	201,861,245	$14.82	$11.61	-21.7%
Africa Oil Corp.	AOI	2,120,742,964	312,333,279	$6.79	$4.14	-39.0%
Bonterra Energy Corp	BNE	2,112,574,633	32,086,492	$65.84	$53.82	-18.3%
Gran Tierra Energy Inc.	GTE	2,003,447,146	274,821,282	$7.29	$5.37	-26.3%
Raging River Exploration Inc.	RRX	1,980,564,289	180,051,299	$11.00	$8.14	-26.0%
Birchcliff Energy Ltd.	BIR	1,969,417,138	150,796,625	$13.06	$9.16	-29.9%
Freehold Royalties Ltd.	FRU	1,925,524,146	74,058,621	$26.00	$21.48	-17.4%
Northern Blizzard Resources Inc.	NBZ	1,914,042,495	101,810,771	$18.80	$15.85	-15.7%
Surge Energy Inc.	SGY	1,889,478,484	217,681,853	$8.68	$6.54	-24.7%
Parex Resources Inc	PXT	1,877,462,466	126,287,061	$14.87	$10.73	-27.8%
Kelt Exploration Ltd.	KEL	1,731,091,845	126,727,075	$13.66	$10.55	-22.8%
Bankers Petroleum Ltd.	BNK	1,721,811,689	260,880,559	$6.60	$4.67	-29.2%
Bellatrix Exploration Ltd	BXE	1,611,292,542	191,364,910	$8.42	$5.59	-33.6%
NuVista Energy Ltd.	NVA	1,583,757,118	135,944,817	$11.65	$10.05	-13.7%
Legacy Oil + Gas Inc	LEG	1,563,886,292	199,730,050	$7.83	$5.06	-35.4%
TORC Oil & Gas Ltd.	TOG	1,362,827,028	93,344,317	$14.60	$11.29	-22.7%
Painted Pony Petroleum Ltd.	PPY	1,362,274,683	93,627,126	$14.55	$11.38	-21.8%
Crew Energy Inc.	CR	1,359,860,601	121,960,592	$11.15	$7.90	-29.1%
Oryx Petroleum Corporation Limited	OXC	1,296,506,662	119,825,015	$10.82	$9.47	-12.5%
Lightstream Resources Ltd.	LTS	1,257,107,698	200,176,385	$6.28	$4.08	-35.0%
Advantage Oil & Gas Ltd.	AAV	1,228,830,837	170,651,966	$7.20	$5.10	-29.2%
Long Run Exploration Ltd.	LRE	1,097,545,166	194,204,965	$5.65	$3.58	-36.7%
Spartan Energy Corp.	SPE	1,096,574,094	262,338,300	$4.18	$3.22	-23.0%
RMP Energy Inc.	RMP	1,068,310,163	122,092,590	$8.75	$6.30	-28.0%

A cursory look reveals that the quoted market price of all of these corporations are significantly less than what they were from August 31st, however, some got hammered more than others.

Whenever one invests in a resource company, there is always the implicit assumption that you believe the commodity price underlying the resource will rise. There is absolutely zero point in investing otherwise unless if there is a very special situation to warrant it (e.g. the firm in question has a huge hedged position on the resource that will allow it to economically outlast its soon-to-be bankrupt peer group).

Ideally you want to invest in a company with a cost structure that is at the marginal point of profitability and that has the market pricing the company assuming it will make little money in the future, and then have the commodity price increase. The embedded leverage in these high cost producers is significant – and I will keep on repeating this – under the assumption that the underlying commodity price increases.

Looking at the “least and most killed” list, we have two companies that I consider to be the cream of the crop in the Canadian oil and gas industry, ARC Resources (TSX: ARX) and Peyto Exploration (TSX: PEY) that are scratched – about 9 and 11% losses, not too bad considering the drop in commodity prices. These two companies have quite good managements and they are very focused on financial return on investment. I actually consider it too bad they did not get a 25 or 30% haircut as they are reasonably good “grandmother and grandfather” type equities that should be able to weather the full storm of a commodity cycle.

On the “ripped to shreds” list, we have Athabasca Oil Corp (TSX: ATH) that I will not touch because they simply have the incorrect economic structure (this can be saved for another post although you can read me correctly passing up on their IPO on this post).

Working the way down the losers list, a few names caught my attention. Lightstream Resources (TSX: LTS), formerly Petrobakken (TSX: PBN) is an entity that I will not be investing in, but I amusingly note that it is finally reaching what I would consider to be a fair value. There was a very dedicated individual out there that was deriding my analysis on its over-valuation which the market finally appeared to have corrected. (Feel free to read these articles here).

However, a couple old titans from the income trust era, Penn West (TSX: PWT) and Pengrowth (TSX: PGF) caught my attention. Penn West notably went through an accounting scandal when they changed top management and the subsequent audit resolved some issues pertaining to the capitalization of what should have been operating expenses. This involved the inflation of the net income line. Having the commodity oil market fall from underneath them did not help either. PWT made the unfortunate mistake of going to natural gas development at precisely the wrong time, but they hold a bunch of other more conventional oil assets which firmly put them in the ordinary category.

Notably they are trading at about a third of their stated book value. One would have to ask themselves if they were to start up that company from scratch how much would be paid to do so. Even when dumping goodwill and accumulated exploration assets (money already spent to do exploration work), there’s still about $4.9 billion in equity on the balance sheet while the market cap is around $2.7 billion today. Just from a fundamental value perspective, while previous investors got hosed, it may be a better entry point than not. The stock is likely to face tax loss selling pressure between now and the rest of the year so there’s not likely any rush to get in on a retail level.

Pengrowth is also going through an ambitious capital plan with the development of a heavy oil resource (their “Lindbergh” project) that apparently has good economics, along the lines of a Cenovus project. There is obvious execution risk with this project as many oil and gas companies have touted the promise of heavy oil while being able to produce nothing. The couple differences I see here is that Pengrowth has been in the game long enough (they’ve been public since 1989) that they should by now know what they’re doing, and also they’ve successfully executed on a pilot project that has dredged up a not trivial amount of oil from the ground already. Time will tell.

Dumping goodwill and exploration assets from PGF’s balance sheet leaves $2.4 billion in book value, while market value is about $2.6 billion presently. On its face it does not appear to be as good a value as PWT, but it appears relatively cheap from a valuation perspective.

Notably, Penn West’s equity is trading with incredibly high implied volatility – about 85% on the January series for an at-the-money option. Pengrowth’s volatility is muted (around 35%). Liquidity in their option markets is garbage, plus trading options on Canadian exchanges is a very expensive process in terms of trading costs.

Both firms give out dividends and are roughly at 10% yield at present market value. Yields might be compromised in the future if oil prices continue to decline. At least investors here clearly are not paying any premium for yield since I think most of them have been scared away from the common stock when they stare at their capital losses – a few months ago they were paying for a 5% yield and while they received that, they got a 50% capital loss in exchange.

The last time oil was at around US$80/barrel was in June 2012. Both companies’ equities were trading at significantly higher levels than they are now, plus they have the advantage of the Canadian dollar being about 10 cents lower than what it was a couple years ago.

Do I have any clue where oil is going in the future? No. However, if you believe things have stabilized, certain oil and gas producer stocks seem to have been sold off disproportionately and would probably make a decent entry point.

Pinetree Capital Re-visited: Another debt opportunity

Please read my prior article, Pinetree Capital: Possibly the worst closed end fund ever, for a good backgrounder on what I am writing about here.

How would you like it if you bought an equity interest in 70 cents per share for the market price of 20 cents?

Normally most people would snap up on the opportunity. Every dollar you invested is backed by over 3 dollars of real net financial assets! What could be the catch?

The catch, of course, is that the assets you are purchasing are illiquid, of dubious value beyond a thin market quotation, and is managed by somebody that has an impressive track record of losing money.

Otherwise the market would not be giving such a steep discount to the whole consolidated operation.

What is interesting is that the capital fund continues to be hampered by debentures that have a 33% ceiling on the debt-to-asset ratio. Last year the fund breached this and had to pay handsomely for the privilege of obtaining more time.

Management has a huge incentive to not let the debtholders take over – surely the big players in the debenture space would liquidate the fund piece by piece and would not be hamstrung by pesky management or their insanely huge salaries.

The debentures, by virtue of the debt-to-asset covenant, are functionally secured, first-in-line debt, next in line to the margin loans the fund has been taking to fund its incredibly speculative investment portfolio.

They also mature in 1 year and 7 months time.

Now that the whole world stock market has tanked over the past month, speculative issues get hammered the most. Pinetree has been suffering, and its equity has thus gone down to the huge discount over stated asset value that you see today.

There is probably some value in the equity, but it will take time to realize the value due to liquidity issues.

However, the real value is in the debentures mainly because they have the noose over management at the moment, who have shown every indication they will dilute and use every trick in the book to maintain control of their lucrative salaries.

Who wants to invest in this train wreck? I don’t know, but if you have a very thick stomach wall for scraping the bottom of the investment barrel, consider purchasing some Pinetree Capital Debentures (TSX: PNP.DB) if you feel brave. There is a reasonable chance that you will be made whole.

Disclosure: I own the debentures.

Market rallies in downward trending markets

It is fairly well known that the largest one-day market rallies occur in the middle of bear market trends. I don’t have the table immediately in front of me, but suffice to say today reminds me of one of those days:

So instead of getting this trickle increase of climbing the “wall of worry”, the rallies are now consisting of manic one-day rallies.

It is thus also not surprising that volatility is trending upwards.

Whatever is happening in the markets is not likely over yet. My guess is that this has to do something with the continuation of the withdrawal of liquidity from the US federal reserve, coupled with trade issues in China and a lacklustre economy in Europe and Japan, with the appreciation of the US dollar vis-a-vis other major world currencies. That was a mouthful?

The only question is that the financial markets make it very difficult to tell which variables are causes of others, and whether the chicken or the egg came first.

Bitcoin valuation review

Here is a chart of milli-Bitcoins to US dollars over the past month:

Anybody having bitcoins over the past month has seen a 1/3rd drop in their US-denominated equity. (As a side note, investors in precious metal gold would have seen a 5% drop in the same time period).

However, the gist of this post is that Bitcoins has long since moved away from the “novelty” factor where people would speculate on them just on the basis of being collectibles (think of Beanie Babies in the late 90’s) and now the market is pricing in true economic worth of Bitcoins – in this case, it is far, far less than what it has been trading for.

Companies and entities that are collecting bitcoins for payment (Overstock.com!) inevitably have to liquidate them or they will continue to face currency risk in transactions.

In addition, it is perfectly obvious at this point that using bitcoins as a currency medium for illicit (silk road, etc.) transactions is just inviting the relevant authorities to digitally track the transactions and make the appropriate associations with the wallets to the identities of the people holding such wallets – the illicit marketeers might as well be writing paper cheques to each other. These illegal trades likely constituted a high amount of the initial bitcoin traffic but this has now ceased.

The only transactions I would see at this point that are economically viable for the medium are currency transactions to avert low denominations of capital controls in countries that are constrained by such measures (think of examples like Argentina, Venezuela and most African dictatorships). I do not see this being particularly viable considering the liquidity of bitcoin markets is nowhere close to institutional levels. In addition, such transactions are indeed illegal in their host countries!

There are structural issues with bitcoin that will continue to hamper its viability, of which I have addressed in earlier posts on this site.

One is that as the blockchain gets bigger and computational difficulty rises, it will become more incumbent upon large digital processors to maintain the transactions. I have already written about the well-known 51% risk where somebody with sufficient computational power over the rest of the network can subvert transactions and simply ruin it for the other 49%. In addition, computational difficulty of Bitcoin continues to increase to levels where it makes no sense except for industrial data-center levels of computational power to operate Bitcoin networks. Ironically, this is not what was envisioned by the pioneers of Bitcoin, which preferred a much more decentralized mechanism to arbitrate the transactions. Instead, concentration will be leading to an obvious state of the union where the 51% owner to the network will be, in effect, the central bank.

Large scale data centers such as ghash.io have pledged to keep under 40%, but why kill your golden goose so prematurely by scaring away dumb money from coming into the marketplace?

There are also more and more other digital currency schemes (Litecoin, Dogecoin, etc.) which continue to trade, but are simply there just to be an alternative to bitcoin – most of the mindshare out there is on bitcoin compared to the alternative currencies. However, with all of these new digital currencies, there are always incumbent advantages – the group establishing the coins will have all the advantages of mining them first, and then with the hopeful attempt to build a marketplace for it so they can just dump it for real currency. Bitcoin has some inherent advantage than other digital currencies simply because the implementation of this was relatively “innocent” compared to most crypto-currencies being created today that are simply there to steal money from other gullible people.

There is the casino-type element of currency trading. I continue to read the Reddit thread and continue to see people with less financial knowledge give out wisdom on Bitcoin. I would be very curious to know the total amount of bitcoin float out there that is simply being held for speculative (i.e. nothing other than for the reason they believe others will believe it is going up) purposes. Now we are reading threads like this or like this, both of which remind me of Canadians that said “I have shares in Nortel purchased at $80, what do I do?”.

Finally, there is the risk that the cryptographic features of Bitcoin that make it very difficult to access other people’s wallets, may be cracked. While this is unlikely, if such a discovery were to be made, it would clearly cause a collapse in the entire Bitcoin system. The only analogy I could make to this in the central banking fiat currency system is having other people being given access to your own bank account at any time without any reversibility (although you can go and find their wallet and spend it right back if you know the algorithm to doing so!). The system would simply collapse.

I can’t see any reason why any Canadian would want to purchase Bitcoins at this time other than for the novelty factor. If you’re planning on buying currency to prepare for the end of the world (whether it be war, hyperinflation or alien abductions), I would not buy something that depended upon a reliable electrical connection, let alone internet connectivity!

Alibaba IPO – thoughts

If you ever had any thoughts of investing in Alibaba (NYSE: BABA), I will just summarize it in this following chart:

The most relevant footnotes are as follows:

(1) Includes approximately 70 subsidiaries and consolidated entities incorporated in China and approximately 120 subsidiaries incorporated in other jurisdictions that are not illustrated in this chart. In addition, the entities pictured in this chart hold, directly and indirectly, an aggregate of approximately 40 additional subsidiaries and consolidated entities incorporated in China and approximately 40 additional subsidiaries incorporated outside of China not pictured in the chart.
(7) Each of these variable interest entities is 80%-owned by Jack Ma and 20%-owned by Simon Xie, other than Zhejiang Taobao Network Co., Ltd., which is 90%-owned by Jack Ma and 10%-owned by Simon Xie.

Good luck figuring out what is beyond the first layer of the corporation and what these variable interest entities are all about. I am reasonably sure insiders will do quite well as long as they are continued to be sanctioned by the state.

Make no mistake – Alibaba is an incredible commercial operation on the level of Ebay and lesser to Amazon, but the people that are going to get rich out of this operation are not going to be the people investing in Alibaba Group Holdings Limited (Cayman Islands) common shares.