Encana deal a signal of future natural gas prices

Encana’s deal with PetroChina, where it sold a 50% interest for $5.4 billion dollars in their Cutbank Ridge property is likely a signal that management believes natural gas prices will remain depressed relative to the run-up experienced in the middle of 2008. The management of PetroChina likely disagrees or is trying to rapidly deploy capital even if they have to pay an expensive price in doing so.

Although the exact terms of the deal are not known, an injection of $5.4 billion in cash leaves Encana in a fairly unleveraged financial position – their total debt at the end of December 2010, net of cash is about US$6.5 billion. Encana will also be spending most of its operating cash flows on capital projects in 2011.

Financial Literacy

The government of Canada commissioned a task force to study the issue of financial literacy in Canada. The report they released can be found here.

I will restrain my comments to say that just as how (in Western Europe) illiteracy was reduced from about 2/3rds in the 18th century to less than 10% today, I would estimate the financial literacy of Canada as being quite low.

By improving financial literacy, people will have a toolbox to make more efficient decisions. Just like literacy today, where you can be bombarded with outright false information, a financially literate population can be bombarded with financial garbage (such as scams that promote a risk-free 30% annual return), but will be better prepared to discard such trash. This is similar as to how people do not take the items printed on the supermarket tabloids seriously.

Financial literacy is a good idea in concept, but it requires a completely different skillset than written literacy – quantitative know-how. Having the mathematical know-how to properly process financial parameters is not an easy skill to teach. Genetic aptitude towards mathematics greatly helps the process.

Liquidation continues

For the first time in a long time, I’m at the 40% cash level. Fortunately this is due to selling securities rather than incurring losses in the portfolio.

When I identified three targets of opportunity in the second half of last year, I should have probably doubled my allocation. This is a classic “should have” case, so it ultimately has no future-bearing consequences. I usually slip into my positions deeper as the price goes lower, and the amount of the price drop on all three securities was not sufficient to get a complete holding since the markets have generally recovered significantly since September.

Having 40% cash means that your holdings have to perform 2/3rds better than the underlying indexes to have an overall performance of the index. As much as I feel like buying puts on the S&P 500 index, standing in front of that freight train is liable to get you financially killed, so I will be patient.

Short term bond ETFs – Watch out

As people start to randomly deploy their capital in February as they attempt to fill their RSPs, fixed income solutions are likely going to be the one-click target. One of them will be bond ETFs.

I’ve noticed some slick marketing that tends to mask probable future performance. For example, BMO has a short term corporate bond fund (TSX: ZCS) advertises a “portfolio yield” of 4.65%. 4.65% sounds very good in context of the risk-free rate of about 2% you can get elsewhere.

The only problem is that when you click on the Holdings page, the weighted average yield to maturity is 2.97%!

Very roughly, what this means is that investors will earn a cash yield of 4.65% (minus the 0.3% management expense fee), but will experience capital depreciation as the bonds approach maturity.

It is likely that fund marketing will concentrate on the yield figure, and completely mask more important numbers such as yield to maturity and duration. This is another technique used to mislead retail investors into thinking they are investing in a produce that is seemingly better than it actually will be.

Long term rates are climbing

Long term interest rates are beginning to climb again. The following is a chart of the 10-year US treasury note:

Rates touched 4% early in April 2010.

The Canadian 10-year bond is exhibiting the same characteristic, with yields up roughly 0.2% over the past week. Fixed income is being sold off and presumably rotated into equities and commodities.

Long term interest rate changes are a crucial variable concerning the pricing of equities and corporate debt simply because they are considered to be a risk-free comparison. With long bond yields rising, fixed rate mortgages will also become more expensive. Right now the best 5-year fixed rate you can obtain is around 3.65%, but this will likely be rising by a quarter point or so in the near future.

The only real defence against sharply increasing interest rates is holding cash or short-duration securities – almost everything else, including gold, will get hammered.