Strange times

This is a post without much direction.

Canadian Macro

Perhaps the largest surprise to occur in the past two weeks was the Bank of Canada deciding to resume interest rate increases. I generally believe that this is an attempt to shake up complacency in the marketplace and that we are approaching the point of diminishing returns. By increasing future implied interest rate expectations, however, is in itself a form of interest rate increase. So we continue to have the triple barreled approach – actual rising interest rates, threatened future interest rates, and quantitative easing. Interest rates started rising on March 2, 2022 and we are about 15 months into the program. As capital hurdle rates have increased and projects that otherwise would have been initiated stall out, we’re probably going to start seeing this slowdown occur pretty soon.

The yield curve remains heavily inverted – right now you can get a 1yr GoC yield of 5.07%, while 10yr is 3.40%, a 167bps difference.

GST/HST inputs, from fiscal 2021-2022 to 2022-2023 (table 2), only rose 2.7% year-to-year, which is a negative real growth in GST-able consumption. This does not bode well overall.

I look at the inflation inputs and it seems intuitive that cost increases will continue to rise above the 2% benchmark – especially on shelter. The interest rate environment (in addition to other roadblocks) is seriously constraining supply, yet demand continues to remain sky-high (one of the effects of letting in a whole bunch of people into the country, including students, which massively raises rental rates in cities).

Inefficient spending

One of the problems of using GDP is that it doesn’t account for unproductive expenditures vs. productive expenditures. If you paid somebody a million dollars to move a pile of dirt from one location to another, and then back again, you would have a million dollars added to the GDP, but the wealth of the country has gone nowhere. That money could have been used for something more productive. If you get enough of this inefficient spending, it starts to show itself in other components of the economy – namely demand for goods/services that clearly are not being supplied because you’ve tasked too many people with moving piles of dirt from one location to another and back again. Those people could have been employed in another activity, say road building, which is a more skillful (and productive) use of moving dirt from one location to another.

It is pretty much the reason why much government spending is inefficient – it gets directed to segments of the economy which are for political purposes rather than productive purposes. Do this enough, and you eventually get inflationary effects in the things that people really need.

A lot of what we have seen over the past 15 years or so can likely be attributed to the cumulative effects of this. While governments are the chief culprit, the private sector as well has significant bouts of inefficient capital allocation (e.g. look at the value destruction in the cannabis sector, or most cryptocurrency ventures, etc.). The “slack” of the misdirection of resources has been exhausted after Covid, and the cumulative impact is truly obvious – a lot of people are going to suffer as a result, and collectively our standard of living will be declining.

Nifty 50 re-lived

The nifty 50 were the top 50 stocks in the US stock market in the 1970’s. Today, the top 10 stocks of the S&P 500 consist of about 30% of the index and many comments have been made about the effect of these stocks on the overall index. In particular, the rebound in technology stocks since November 2022 has caught many fund managers by surprise, and it is to the point where essentially if you did not own them (Facebook/Meta, Nvidia, etc.), most closet index fund managers would have badly underperformed. Perhaps it is sour grapes from somebody like myself (where I am barely treading water for the year), but this just does not look healthy.

Safe returns

Cash (various ETFs) return about 5.08% at the moment. For yield-based investors this is a very high hurdle. For example, looking at A&W Income Fund (TSX: AW.UN) with its stated yield of 5.3% – while you do get a degree of inflation protection, how much can burger prices rise before you start seeing volume slowdowns (and it is volume, not profitability that counts for these types of royalty companies)? Cash is out-competing much of the market right now. With every rise in the short-term interest rate, the differential widens.

Everybody looks at the charts of long-term treasury bonds in the early 1980’s and said to themselves “if only I had gone all-in on those 30-year government bonds yielding 15%, I would have made out like gangbusters”. This is almost the equivalent of saying your ideal timing into the stock market is February 2009, or March 23, 2020. The problem with such statements, other than they are entirely “hindsight is 20/20”, is that in order to get those 15% yields, such a bond needs to trade at 10%, 12%, 14%, etc., before reaching that 15% point. Valuations that would seem attractive and bought before that 15% yield point will have unrealized losses, sometimes significant, at the crescendo event. This is usually the point where most leveraged players are forced to be cashed out at the violent price action.

Parking cash is boring, and likely will result in the loss of purchasing power over periods of time (the CPI is a terrible barometer for ‘real’ consumer inflation), but better to lose 5% of purchasing power instead of 40% in a market crash!

Implied volatility

The so-called ‘fear gauge’ (the 1-month lookahead volatility of the S&P 500) is getting down to 2019 lows:

I don’t know what to make of this. Markets price surprises and probably the biggest surprise is a rip to the upside, despite all of the doom-and-gloom that the macro situation would otherwise suggest – perhaps interest rates are going to rise even further than most expect?

Either way, I’m not going to be a market hero. I remain very defensively postured and I do not feel like I have much of an edge at the moment. When you had everybody losing their heads over Covid three years ago there was a ripe moment where the reality vs. psychology mismatch created huge opportunities. Today, the normalization of this reality vs. psychology has created much more efficient market pricing. I can’t compete in this environment which feels like trading random noise. Maybe the AIs have whittled away the differential between reality and psychology – but they are only as good as the data that gets fed into them, and markets tend to exhibit random patterns of chaos now and then which will throw off the computers. So I wait.

If you ever wonder why I can’t work in an institutional environment, it is due to having some radical thoughts like the last paragraph.

An amusing moment – Reading the Bank of Canada financial statement

Reading the Bank of Canada’s 1st quarterly statement in 2023, the key table is:

Indeed, they booked a comprehensive income loss of $1.535 billion for the quarter, or about $40.13 per diluted Canadian.

The thought that immediately went into my mind was… “How come the Office of the Superintendent of Financial Institutions hasn’t taken over this bank yet?”

It’s exactly the same situation as Silicon Valley Bank or Signature Bankcorp – you have a balance sheet that is addled with low-coupon long-term government securities, coupled with paying out most of your balance sheet with a higher interest rate. At least with SIVB and SBNY you had a positive net interest margin, while the Bank of Canada’s is running at an annualized NEGATIVE 1.6%! That’s even after having a captive audience of over $110 billion of zero-yielding deposits (in the form of coloured polymer banknotes!).

That’s government I guess!

Rights of First Refusal coming in handy – Surmont Oil Sands

Suncor, April 27, 2023:

Suncor Energy (TSX: SU) (NYSE: SU) today announced that it has agreed to purchase TotalEnergies’ Canadian operations through the acquisition of TotalEnergies EP Canada Ltd., which holds a 31.23% working interest in the Fort Hills oil sands mining project (Fort Hills) and a 50% working interest in the Surmont in situ asset. This will add 135,000 barrels per day of net bitumen production capacity and 2.1 billion barrels of proved and probable reserves to Suncor’s oil sands portfolio. The acquisition is for cash consideration of $5.5 billion, with the potential for additional payments of up to an aggregate maximum of $600 million, conditional upon Western Canadian Select benchmark pricing and certain production targets. Subject to closing, the transaction will have an effective date of April 1, 2023.

Two assets were purchased. It wasn’t entirely clear what the price allocation between both assets were. Now we know:

31.23% Fort Hills – CAD$1.5 billion / $160 million contingent consideration
50% Surmont oil sands – CAD$4.0 billion / $440 million contingent consideration

Suncor purchased from Teck 21.3% (minus Total Energies’ right of first refusal component of 6.65%) for $1 billion. Suncor ended up with another 14.65% in total. The 31.23% consideration for $1.5 billion is roughly in-line with what Teck paid.

How did we figure this out the split between the two major assets?

May 26, 2023:

ConocoPhillips (NYSE: COP) today announced that it is exercising its preemption right to purchase the remaining 50% interest in Surmont from TotalEnergies EP Canada Ltd. for approximately $3 billion (CAD$4 billion), subject to customary adjustments, as well as contingent payments of up to approximately $325 million (CAD$440 million). ConocoPhillips currently holds a 50% interest as operator of Surmont and will own 100% upon closing. This transaction is subject to regulatory approvals and other customary closing conditions.

Here’s the kicker:

Based on $60 WTI, the transaction will add approximately $600 million of annual free cash flow in 2024, inclusive of approximately $100 million of annual capex for maintenance and pad development costs.

That’s US dollars – US$60 WTI = US$600 free cash flow, or about CAD$817 million. Suncor was paying about 5.4x free cash flow. Logically it is even better when WTI is greater than US$60! This should have been a pretty easy decision for ConocoPhillips to exercise the right of first refusal.

All of this was unfortunate because Total Energies was planning on doing a spinoff of these two assets and depending on valuation, I was planning on getting into this firesale. No longer!

It is no kidding that Suncor stock is down today – Surmont is 75,000 boe/d of low-cost production. Fort Hills has a rated capacity of 194,000 boe/d. While it is a nice consolation prize (especially as the entire operation is now consolidated in Suncor), the Surmont asset is something I’d like to get into at the price Suncor was paying!

Alberta Election 2023’s impact on oil and gas companies

I try to avoid politics on this site other than the direct impact of various policies on investment values.

That said, the upcoming Alberta provincial election, scheduled for May 29, 2023, is a significant political event risk for most of the publicly traded Canadian oil and gas companies, especially CNQ, CVE and SU.

Unlike most of the promises that both major provincial parties talk about and will never deliver on, I think it is safe to say that it is universally agreed that it is a near-certainty that the provincial corporate income tax will rise from 8% to 11% if the Alberta NDP is elected.

The oil and gas producers of Alberta continue to deliver a huge amount of corporate profits at the moment. Pretty much all of the large capitalization companies have exhausted their available tax shields. Since oil and gas production is a price-taker industry, the cost of a corporate tax increase gets directly borne by the shareholders (i.e. the companies cannot all unilaterally raise their prices, which is set by an international market).

The present value of four years of a 3% corporate tax increase on a company such as Cenovus, at WTI US$73 and everything else being equal would be about 35 cents per share.

There is other baked in assumptions that come politically (e.g. royalty regime changes, asset retirement obligation changes, regulatory changes and other indirect taxation changes on fossil fuels) which would increase costs to shareholders.

In essence, you can indirectly infer what market participants think about the election through oil and gas stock prices. The May 5, 2015 election result (caused by a significant split in the Progressive Conservative party) led to Alberta-based oil and gas equities to drop around 5-6%.

This time around, there is no significant split in the right wing of the political spectrum, which would be to the detriment of the Alberta NDP. Indeed, this election is looking to be the most polarized election since 1913, where the top two parties received 94.33% of the vote. Needless to say, Alberta has changed a lot since then.

Opinion polling would suggest that the UCP is going to win, but inevitably the makeup of the voter turnout in “swing seats” (i.e. in certain parts of Calgary, and outer fringes of Edmonton) will determine the outcome of this election. Pretty much all the messaging of the two major political parties is geared towards this mostly sub-urban geography.

My political projection has the UCP winning with about 55 seats (44/87 needed for a majority). The NDP will do much better on popular vote because the remnants of the Alberta Liberals and Alberta Party will coalesce into the “not UCP” camp, but even with around 45% of the vote, it will be insufficient due to the extreme polarization this election.

US Regional Banks

Like a moth flying around a campfire, it is easy to fly in and get incinerated. But I can’t resist looking at more of these regional banks. When you have a lot of third parties claiming to be purchasing puts on the next one bound to be FDIC’ed (the earthquake, in my view, appears to be finished), one would suspect that there is going to be a boomerang effect on these entities as shorts get cleaned out.

The one I’ve been looking at is Customers Bankcorp (NYSE: CUBI), notably because it doesn’t pay a common share dividend and is trading well below book value.

By most accounts it is not an atypical regional bank. It does the usual stuff. The borrow, however, has jacked up from 50bps to 800bps over a month.

In many instances, looking at a chart before the 2020 Covid crisis hit should be a reasonable barometer of economic health of these firms. Indeed, CUBI at this era was around $20-25/share, which is its present trading price.

However, 2019 featured something that we do not have today. A positively sloped yield curve.

Playing around with the dynamic yield curve chart, the short term to long term curve has nearly always featured a positive slope for most of the 2010’s decade.

Today that is heavily negative.

So while there is an argument to be made that entities such as CUBI can run off their books and an investor can claim capital appreciation, theoretically speaking the economic environment for a bank (traditionally having a finance model of “lend long and borrow short”) continues to remain incredibly adverse to profitability, especially as more and more customers want to escape zero/low-yield purgatory for idle cash and can do so with a click of a few mouse buttons.

This moth is happy to stay away from the campfire.