Canada – Page 16

Canadian oil wipeout

Western Canadian Select is trading at US$17.28 this very moment. For comparison, West Texas is around US$70, and Brent is US$80.

It is well known that Canadian Western crude has a heavy price discount due to the inability to transport it to market. Line 3 (ENB), Keystone (TRP) and Trans-Mountain (KMI/KML, now the Government of Canada) are the only three “quick and cheap” ways to getting it out and these lines are already full.

However, this discount has been much more pronounced over the past quarter and if it continues, it will be financially catastrophic to those companies that are over leveraged and have covenant issues.

The question is to what degree this is reflected in current Canadian oil asset prices. The solvency situation for a lot of companies are likely to get worse than better in the near-term.

It is also amazing how political considerations can stall an entire industry. The survivors will be the well-capitalized incumbents that will pick away strategically at assets of those which are forced to liquidate. Suncor, CNQ and the like with independent channels for energy distribution will pick away at the entrails of smaller, less capitalized competitors.

What I am trying to say here is that small-cap oil, especially those over-leveraged, look to be an incredible value trap on the equity side. There may be debt opportunities here and there, however.

Canadian Dollar vs. US Dollar

This chart has grabbed my attention over the past couple weeks:

The market is trading CAD up presumably on hopes that Canada and the USA can iron out some sort of trade deal on the NAFTA front. I’d be skeptical. The politics does not work very well for both President and Prime Minister for a quick agreement.

The other drivers of the Canadian currency are interest rates and the state of the commodity markets, and relative to the USA, neither appear to be favouring the Canadian dollar at the moment.

That said I do not pretend to understand all the nuances of Canadian dollar trading, so perhaps some other enlightened individuals can chime in.

Canadian Dollar, Genworth MI and Residential REITs

This will be a rambling post in no particular order.

1. The Canadian dollar has tumbled with Donald Trump beating the war drums on the trade portfolio:

This will keep going lower and lower until the Government of Canada realizes that a lower currency doesn’t mean you’re more competitive when you’ve basically killed your own industry. Normally there is correlation between oil prices and the Canadian dollar but this linkage has now been considerably more muted because of WTIC to Alberta oil differentials. Investment has been flowing away from Alberta/SK oil and everything is on maintenance mode.

This will clear the way, however, for the Bank of Canada to raise interest rates another quarter point.

Domestically, this is going to be a disaster for general Canadian standards of living. It seems to be that our largest urban export is continuing to be real estate.

2. Speaking of real estate, bearish market participants in Genworth MI are going to face a short squeeze:

I’m not sure why anybody would want to use Genworth MI as a proxy for Canadian housing when there are so many more other investment vehicles to express this sentiment, ones that are trading well above book value and are making nowhere close to as much money as Genworth MI is on their insurance portfolio.

I’ll send a “hat tip” to Tyler, who writes infrequently at Canadian Value Stocks, for the brief mention of my continuing analysis of Genworth MI. The best analogy I can give is “picking up hundred dollar bills in front of a steamroller” instead of the usual cliche of “picking up nickels”. Genworth MI is claimed to be poised to have a giant collapse, but the variables required to make that happen seem distant at this point in time. Hint: Pay attention to China.

3. Speaking of real estate, the most hyped investment seems to be mortgage REITs and also residential REITs. The cap rates received by purchasers are incredibly low. Example press release linked here, key quotation in the first paragraph:

Northview Apartment Real Estate Investment Trust (“Northview”) (TSX:NVU.UN) today announced that it has agreed to acquire a 623 unit portfolio of six apartment properties (the “Acquisition Properties” or the “Acquisition”) from affiliates of Starlight Group Property Holdings Inc. (“Starlight”). The aggregate purchase price of the Acquisition Properties is $151.8 million (excluding closing costs), representing a weighted average capitalization rate of 4.5%.

A 4.5% cap rate? Do I even need to open a spreadsheet to know that the purchasing side of the transaction is wholly reliant on capital appreciation of the underlying properties for this to make financial sense?

The big favourite in this market is Canadian Apartment Properties (TSX: CAR.UN) and they probably can’t even believe how much their equity has traded up over the past year. They did a secondary at $35.15/unit and probably feel like idiots since just three months later they’re trading at $43/unit.

We drill down into their financials and see that from the last quarter, extended to 12 months, their normalized funds flow through operations (recall that accounting rules will add gross amounts of volatility in REITs due to mark-to-market rules when properties are re-appraised and this difference will be added or subtracted from income, making standard income statement comparisons incomprehensible without going through mental gymnastics) results in a net yield of about 4.3%.

An investment in CAR, therefore will expect to receive 4.3% plus the variable components of changes of rental amounts, property values, financing and operating expenses, and vacancy rates. Will these variable components be enough to give a rational equity investor a higher rate of return as surely nobody would want to take equity risk for a measly 4.3% gain?

The Canada-USA trade war is not going to end well

The US administration is using a tariff on steel and aluminum imported from Canada, Mexico and the EU. They had threatened to do that before in March, but exempted Canada and Mexico during that round (notably Prime Minister Justin Trudeau took “credit” for this). Now the tariffs are in place, effective yesterday.

Presumably this is part of a negotiation concerning NAFTA which hasn’t gotten the results the US administration wants.

Canada’s response is here, which they claim to consist of CAD$16.6 billion that the USA will levy against Canadians.

Included is not only steel and aluminum, but other household products. This includes yogurt, roasted coffee (although not decaffeinated!), strawberry jam, non-frozen orange juice… in other words, my breakfast is going to get 10% more expensive!

Here’s the big problem with the “tit-for-tat” strategy that Canada is employing: The USA has a lot more money than Canada does. If the USA decides to raise the stakes and put on another $50 billion in tariffs, what US imports are Canada going to go after next?

It’s pretty clear where this end-game is going to go – the purchasing power of the Canadian dollar will drop.

My other comment is that Ontario is the most sensitive province to steel and aluminum import tariffs. They are also undergoing a provincial election at the moment which has a strong possibility of a minority government (which means paralysis). Finally, Ontario is 40% of Canada’s GDP, so the US tariffs hit the correct part if the USA wanted to make some political impact. They clearly know what they’re doing.

Short-term Canadian Interest Rates

The Bank of Canada’s next interest rate decision will be on May 30th.

Pundits are saying the bank will stand pat, citing various economic statistics, trade uncertainty with NAFTA, lunar cycles, etc.

There is one other statistic that matters much more than others, and it is the following chart (10-year government bond yield):

As long as the spread between short-term rates and the 10-year yield remains greater than a percentage point, this gives them clearance to raise rates, especially when lock-step with the Federal Reserve.

My prediction, if it wasn’t obvious by the tone of the previous writing is, that barring some major change or news over the next week, the Bank of Canada will raise the short-term target rate to 1.5% (up 0.25%) on May 30th of this year.

Right now the 3-month Bankers’ Acceptance is at 1.69% which translates into 98.31 on the futures contract. Currently the June 2018 BAX Futures are trading at 1.81% (98.19), which also factors in some interest rate probability concerning the July 11, 2018 decision.

(Update, May 29, 2018: Given that 2, 5 and 10 year rates have dropped significantly in the past week, I’m withdrawing my prediction. Next cycle will depend on the rate spread between short-term and 10-year yields.)