Can Teck unload their met coal operation?

Teck (TSX: TECK.A/B) had some interesting news yesterday – they dumped their 21% interest in the Fort Hills oil sands project for $1 billion to Suncor (the majority owner and operator), and they also released their quarterly report.

The Fort Hills project was the black sheep of Teck, primarily because it goes against their “wokeist” image they are trying to project and is clearly not in their strategic mandate to be a lead producer of “low carbon metals” (aren’t all metals non-carbon?). Once the Frontier Oil Sands project was shelved, pretty much the days were numbered for the Fort Hills division.

For Q3, Teck’s share of the project was 37,736 barrels of oil a day, and the consolidated project is 180,000 barrels – not a trivial size.

The project historically has been plagued by operational issues and, in my quick evaluation, the deal is good for both Teck (who wanted to get out) and Suncor (who is likely to consolidate 100% of the project in the near future). The Frontier project might get revived in a future decade when regulatory concerns get alleviated, but I would not hold your breath.

Of note is that both companies (Teck and Suncor) will be taking non-cash accounting losses on the disposition – in Teck’s case, the amount of capital dumped onto the project is less than the amount that they were able to get back from it with this disposition. The impairment charge on the books was $952 million. The conference call transcript indicated there was a ‘small capital loss’ on the transaction.

Teck’s major project in the works is the QB2 copper mine in Chile. One reason why their stock had a tepid response to the quarterly report is because of the usual announcements of delays and construction cost escalation, coupled with a decreased expectation for production in 2023. However, this is yet another sign that one cannot click a few buttons on Amazon and expect a mine to start producing – the scale and scope of these projects is gigantic and this one has taken about 5 years to get going from the “go-ahead” decision to when things will be materially completed. If this decision was pursued today, the costs would likely be even higher (not to mention the regulatory climate would be even worse than it is today).

QB2 is the example of their “low carbon metals” strategy, where apparently they can be dug up from the ground without emitting carbon, but I digress. The “to-go” capital expenditure on QB2 is anticipated to be US$1.5-$1.9 billion from October 1, and once this is completed, Teck will be a free cash flow machine barring some sort of total collapse in the copper market (beyond the 30% drop from half a year ago).

The balance sheet is very well positioned, with $2.6 billion in cash and no major debt maturities until 2030 other than a US$108 million bond due February 2023, which they can easily pay off. As a result, Teck will be in a position to either buy back stock or issue increased dividends later in 2023.

But the focus of this post isn’t about QB2 or Teck’s future prospects, it is about their metallurgical coal operation.

Their met coal operation generated $1.24 billion in gross profits in Q3, and $5.55 billion year-to-date. It is single-handedly the reason why Teck is in such a fortunate financial position to be able to dither on QB2 and not get terribly concerned about it.

However, it flies in the face of their “low carbon metals” strategy and this reminds me of last year’s article which rumoured that Teck was looking at getting rid of, or spinning off their met coal operation.

My question is still the same – who would buy this? It is making so much money that even if you paid 2x annualized gross profits (an incredibly generous low multiple), somebody would still need to cough up $15 billion to buy the operation. This puts pretty much every coal operator out there except for the super-majors (like Glencore) out of the picture.

However, if Teck were to dispose of the coal unit, it would likely be in conjunction with a significant distribution to shareholders – a $15 billion sale would result in roughly a $22/share distribution, assuming a 25% tax rate (the actual tax paid will likely be less since Teck’s cost basis will be considerably higher from the Fording Coal acquisition). At a zero-tax rate, that would be roughly $29/share.

However, a giveaway is the non-answer during the conference call:

Orest Wowkodaw
Analyst, Scotia Capital, Inc.
Hi. Thank you. Jonathan, your number two priority seems to be rebalancing the portfolio to low carbon metals. I’m wondering if that if your strategy there is solely around growing the copper business and i.e. diluting the coal business, or do you see the potential for accelerating that transformation perhaps by either divesting some of the coal business?

Jonathan Price
Chief Executive Officer & Director, Teck Resources Limited
Yeah. Hi, Orest, and thanks for the question. There’s a number of approaches that we’ve been taking to that. The first as you’ve seen overnight is the announced divestments of Fort Hills. Clearly oil sands carbon, an opportunity there to reduce weight in the portfolio through that divestment, something we’re very pleased to have agreed and have gotten away.

Secondly, as you highlight really the key approach for us is the growth around copper with the doubling of copper production as we bring QB2 online next year. And then with the projects I mentioned being new range being San Nicolás being the QB mill expansion all bring more copper units into the portfolio which further swing us towards green metals and away from carbon. As we’ve said before, we’ll always remain very active and thoughtful in reviewing the shape of the portfolio and the composition of our portfolio. But right now those factors I’ve mentioned are the key execution priorities and that’s what the team is focused on. And that’s what we’re gearing up to deliver.

I’m pretty sure reading between the lines that they are, at the minimum, thinking of doing this. But who in their right mind would buy such an operation in a very hostile jurisdiction?

Long-term government bonds

Yields are now higher on 30-year government bonds than they have been since 2011.

There was a time where you could put money away into government debt and earn a satisfactory return on investment, especially if you are into the annuity-type investments. For example, if you bottom-ticked the 30-Year US treasury bond in September 1981, your yield to maturity would have been north of 15%. Ignoring the coupon differential (as those bonds surely at the time would have been trading at a discount), pouring a million dollars into fixed income would yield off $150k/year for the next 30, virtually guaranteeing a high cash stream.

At the same time, your dreams of going into margin to buy such a financial product would have been unattractive because short term rates would have spiked up to 21% at the time. Speculating on buying 30-year government debt was exceptionally difficult at the time – high inflation, a massive recession, and just doom and gloom everywhere. Of course, such times tend to be perfect for buying assets which are being liquidated wholesale.

Timing the market is always subject to psychological urges and always looks easier in retrospect. One year earlier, in September 1980, the same bond yielded around 11%. At that time, CPI inflation from 1979 to 1980 averaged 13.5% and such a long-term investment would seemingly have been locking in a real negative rate of return. Had you invested in the 11% yielding long bond at the time, over the course of the following year you would still be sitting on significant capital losses (about 25%) a year later and looked quite stupid.

I don’t think we’re going to get to that magnitude of interest rates, but there is going to be a parallel between how CPI persists, and the continuing downward slope of the yield curve. It doesn’t appear to be the right time to pounce. It’s just not painful enough.

Don’t get me started on whoever got trapped into buying these things a year ago when yields were less than 2% – they’ve lost over a third of their capital at present. A large cohort would be pension funds that have gotten annihilated on fixed income, coupled with insurance companies that keep the bulk of their capital into the same financial instruments. Look to see massive losses on the comprehensive statements of income from these entities when they announce their upcoming quarters.

The Biden Oil Put

Link to: FACT SHEET: President Biden to Announce New Actions to Strengthen U.S. Energy Security, Encourage Production, and Bring Down Costs

Quote:

DOE has finalized a first-of-its-kind rule that enables it to enter into fixed-price contracts with suppliers, through a competitive bid process, to repurchase oil for future delivery windows. This new authority will shore up demand for oil when supply is less uncertain and prices are anticipated to be lower. For example, if the market were to price barrels for delivery in mid-2024 at $70, the new rule allows DOE to enter into a contract now for mid-2024 delivery of oil at, around or lower than that price. DOE plans to use this authority to enter into contracts to repurchase oil for the SPR, targeting a price of about $67 to $72 per barrel or lower, with initial repurchases being delivered in 2024 or 2025. In addition, DOE is prepared to undertake additional SPR repurchases at times when the price of oil for current delivery drops to about $67 to $72 per barrel or lower, supplementing its future fixed-price contracts as appropriate.

SPR Reserves – September 30: 416,319 million barrels remaining – October and November will feature another 25 million barrels or so out of the reserve.

Notably with the above quotation, it puts an effective floor on oil pricing for a certain amount of capacity. This has the makings of a one-way trade, providing that demand does not collapse to the point where prices go even lower than that due to perhaps an impending recession in 2023.

Always interesting times ahead, navigate carefully!

Patience

Most of financial media is designed to get you to trade around your positions. There is always attention deficit disorder-inducing information about some minute development that tries to nudge you to getting in or out of positions.

Such actions are most typically very destructive for performance and also the disposition of securities destroy long-term benefits of tax deferrals on non-registered accounts.

There are times to pounce and there are times to just twiddle your thumbs and spend 10 bucks on a Netflix subscription and catch up on the soap operas. (I’m trying to make a modern-day version of a phrase Warren Buffett used to describe himself about “going to the movies” instead of taking an action in the market that he later regretted).

Right now is one of those times.

The Bank of Canada is going to raise interest rates on October 26, quite likely 0.5% to 3.75%. Then the Federal Reserve is going to raise interest rates on November 2, quite likely to the 3.75-4.00% range.

In both cases, QT continues concurrent to rate increases. The Bank of Canada has $370 billion in federal government bonds, and $17.6 billion goes off the books at month end. The US Federal Reserve peaked at $5.771 trillion in treasury securities at the beginning of June and is now at $5.629 trillion – and is mandated to drop $0.06 trillion a month.

While liquidity levels are ample, it is decreasing. The cost of capital is rising – while you can still get capital, it is a lot more expensive than it used to be.

Laying in the financial bushes and stalking targets is the mode of the day. In the meantime, cash is offering a dividend level not seen in well over a decade.

Lacy Hunt on the Federal Reserve

The Hoisington Investment Management Company has been completely slammed in the past year because of their bullish projections on long-dated treasury bonds, but one of their principals, Lacy Hunt, makes for always educational reading. The fund’s Q3 commentary is well worth reading. Key takeaway:

The Fed’s mettle will be tested because highly over leveraged institutions will fail as they historically have done in such situations. Bad actors or their enablers should be directed to bring their collateral to the discount window or, if necessary, to the bankruptcy process rather than be given bailouts that have severely widened the income and wealth divides in the U.S. while causing the Fed to sacrifice price stability that’s so essential for broad-based economic gains.

This is the goal of using monetary policy in the current circumstances – there is no gain without pain. And the pain is coming.

We look at the trajectory of the 30-year US bond yield:

An investor that was long this since the beginning of the year (a rough proxy for a 25-year duration product is TLT) would be down about 32% on price. This is more than the S&P 500, which has seen “only” 25% depreciation to date.

Does the pain get worse? Probably. I’m wondering what institutions out there are unduly exposed to the 30-year yield rising to some “unthinkable” level, say, 500bps before they blow up. Just remember – in September 1981, the 30-year yield got to 15.2%!