PWT – Divestor

A nice time to be holding cash

This is a rambling post.

Downward volatility is the best friend of an investor that has plenty of cash.

You will also see these punctuated by magnificent rallies upwards which will get everybody that wanted to get in thinking they should have gotten in, until the floor drops from them again which explains today.

By virtue of having well over half cash and watching the carnage, I’m still not finding anything in fire-sale range except for items in the oil and gas industry which are having their own issues for rather obvious reasons. Examples: Penn West (TSX: PWT) and Pengrowth (TSX: PGF) simultaneously made announcements scrapping and cutting the dividends, respectively, and announcing capital expenditure reductions and their equity both tanked over 10% today. Crescent Point (TSX: CPG) had a fairly good “V” bounce on their chart, but until oil companies as an aggregate start going into bankruptcy and disappearing, it is still going to be a brutal sector to extract investor value from.

I just imagine if I was one of the big 5 banks in Canada and having a half billion line of credit that is fully drawn out in one of these companies. Although you’re secured, you don’t envy the train wreck you have to inherit if your creditors pull the plug.

The REIT sector appears to be relatively stable. Looking at charts of the top 10 majors by market capitalization, you don’t see a recession in those charts. If there was a true downturn you’d expect to see depreciation in the major income trusts. I don’t see it, at least not yet.

Even when I exhaustively explore all the Canadian debentures that are publicly traded, I do not see anything that is compelling. The last debt investment which was glaringly undervalued was Pinetree Capital (TSX: PNP.DB) – but this was in February. They recently executed on another debt redemption which puts them on course to (barely) fulfilling their debt covenants provided they can squeeze more blood from their rock of a portfolio. I wouldn’t invest any further in them since most of what they have left is junk assets (Level 3 assets which will be very difficult to liquidate). One of those investments is a senior secured $3 million investment (12% coupon!) in notes of Keek (TSXV: KEK) which somehow managed to raise equity financing very recently.

The preferred share market has interesting elements to them as well. Although I’m looking for capital appreciation and not yield, it is odd how there are some issuers that are trading at compellingly low valuations – even when factoring in significant dividend cuts due to rate resets (linked to 5-year Government of Canada treasury bonds yielding 0.77%!). I wonder if Canada’s bond market will go negative yield like some countries in Europe have – if so, it means those rate reset preferred shares will have even further to decline!

Oil and gas

As readers may suspect, I have been intensively looking at the oil and gas producer market directly as a response to the rapid decrease in world oil commodity prices over the past three months.

I don’t know whether oil is going up or down from here, but from the US$75 perch it is at today, I would suspect it is more likely than not we will see a US$100 (+33%) WTIC barrel price rather than US$50 (-33%).

I decided to restrict my choices to strictly oil and gas producers that are within the confines of Canada. I have a fairly solid grasp of the regulatory and legal side of what Canadian producers face and also a good feel for the political climate that may drive economic changes within the various firms (e.g. provincial governments deciding to tinker with royalty rates).

Go take a look at Transglobe (TGL.TO) if you believe you have any idea what the political-economic stability of Egypt is. If you think they will be all right, then you’ll stand to make a small fortune.

In the Canadian world, crude oil trades at a discount to the prevailing WTIC price for a variety of reasons. Heavy oil producers have an even higher penalty on pricing. The differential is unlikely to change soon and this has generally been the focus of the Canadian government to address the differential (via pipelines, and opening up an export route to east Asia via BC which is not likely to happen anytime soon). The discount that Canadian crude has over the prevailing North American price is a significant economic issue for those that derive their living from Canadian energy, but it is such a political issue that I will stop talking about it here. What is financially relevant, however, is the market is very well aware of this and is not pricing in any anticipation of the Canadian pricing disadvantage stopping anytime soon.

I will give an example. If a surprise deal is reached with the relevant First Nations bands in British Columbia and the Northern Gateway project is commenced, you would see a huge spike in Canadian oil and gas producers for sure.

After doing a ridiculous amount of exhaustive analysis, I realize that from my third party perspective it is going to be very difficult to pick alpha from companies that have very cookie-cutter characteristics and that indexing is the better way to go. Unfortunately most Canadian indicies and ETFs (e.g. XEG.TO) involve a huge concentration of Suncor, CNQ, Cenovus, Crescent Point, EnCana, Husky, etc., and while I think these are fine companies that will likely survive to the point when I start collecting Old Age Security, they do not offer the most potential for appreciation. So instead of going for an index ETF, I decided to just create my own mini-ETF with a few positions. I have taken a position in three companies with average sized positions. I had intended to do four but one of the names has since climbed higher than what I was willing to pay for it.

I’ve decided on creating a mini-index for myself consisting of PWT.TO, PGF.TO and DTX.TO. The first two should be well known to most people. They have been around since the former income trust glory days and are income-oriented investments. Despite the fact that they have massively huge yields (which had nothing to do with the investment decision at all), I generally believe PWT’s new management is on the right track (reduce debt, focus on costs, be up-front with shareholders when your previous CFO was over-aggressively capitalizing expenses, etc.). PWT is unhedged.

PGF has an heavy oil project that is being heavily discounted by the market simply because they are throwing so much more cash out presently than they are taking in, but they will receive a huge benefit from such expenditures from 2015 onwards in a Cenovus-like manner and then they will be able to get their debt metrics in order. They have hedged roughly 2/3rds of their 2015 production at ~US$84 and from there they will appropriately try to game the commodity market.

DTX, whether through luck or purposeful selection, appears to be a very heavily profitable producer. They don’t give out a dividend because they want to grow (which is exactly what they should be doing given their reinvestment returns). They’ve hedged about 1/6th of their production in 2015 at around US$88-ish (good market timing!).

There’s more to the above stories but I will leave it at that.

The price depreciation over the past half year in all of these issues has led to a margin of error factor that appears to present a good risk-reward ratio.

The last name that I wanted to include on the list was something heavy in gas rather than oil, and that was Birchcliff (BIR.TO). Unfortunately in their case, after I did my due diligence on them a couple weeks later than I should have and I was looking at a stock price that I thought I could time the market better than what actually happened (take a look at their last month of trading and you will see why). If they sink again to the single digits, I will likely be taking a position in them.

I wish a company like Peyto would crash down 50% but clearly this isn’t going to happen.

All of these companies have a possibility of being taken over by larger producers. They also all have insider purchases, which was a partial consideration in my sweep of companies.

I want to thank Neil J who offered some interesting comments on a previous post of mine. There is no way I would have reviewed DTX if it wasn’t for his comments. I very rarely pick off names that are brought to my attention in this fashion, but this was a rare, rare exception.

Given my relative uncertainty in underlying commodity prices (I am not a fan of commodities in general at this point in time, but I am making a very special exception for energy), I do not anticipate taking more than a total 20% position combined in oil and gas producers and related firms, but this is probably more weighing I’ve had in the sector for quite some time. I am comfortable holding this until we start seeing stories of peak oil and this sort of stuff again.

Reviewing underperforming Canadian oil and gas producers

One observation: It is abundantly clear that oil and gas producers in North America are going to be trimming their 2015 capital budgets. This will disproportionately affect the service companies, but most of this has already been baked into equity prices.

I have no idea where oil prices will be going in the short term. There is plenty of incentive for those that have already sunk a boatload of costs into their wells to keep them flowing. In the short term you might see some price shocks, but in the medium and long term, I cannot see oil losing too much demand relative to supply levels. While getting into my vehicle and experiencing heavy traffic is hardly a statistical sample that you can extrapolate across the world, intuitively I do not think electrification of transportation is going to be an imminent threat on crude oil (or natural gas) as being the transport fuel of choice. Nor do I see the requirements for plastics or any derivative products of crude being replaced anytime soon.

The point of the preceding paragraph is that crude oil is not going to disappear off the map anytime soon (unlike its predecessor, which was whale oil).

With my very generalized valuation theory on oil and gas producers that “oil prices are a reasonable proxy for company performance plus financial leverage effects”, I note that WTIC (West Texas Intermediate Crude) reached the US$80/barrel level back in June of 2012:

A very simple theory is that oil and gas producers that are trading below what they were trading in June of 2012 should be given a second look to see what caused their relative dis-valuation from present oil levels. A surprisingly large number of Canadian oil and gas companies are trading well above their June 2012 levels despite the oil price difference.

One reason is simply due to good (or lucky timing!) hedging strategies.

Another is due to the mix of oil (and the different types of oil), transport issues, and the percentage of natural gas and natural gas liquids in the revenue mix of a company – in general, while you aren’t suffering pure hell at US$2.50/GJ back in June 2012, your typical gas driller hasn’t been wildly profitable compared to the good ol’ days back in 2008 when you were at US$10.

There’s also the simple reason of having excessive financial leverage and not being able to finance the corporation at revenues obtained at current prices.

There’s plenty of reasons why an oil and gas company would be trading lower today than in even worse price environments seen in June 2012.

So given everything trading on the TSX, I’ve done some homework as a starting point and gone through the companies with the following criteria:
– Share price over CAD$2
– Market cap over $1 billion
– Not a foreign entity (although they can have foreign operations).
– Trading lower today than they generally were in June 2012.

We have, in descending order of market cap:

CVE.TO
TLM.TO (not that they’ve been having difficulties lately!)
BTE.TO
PWT.TO
PGF.TO
TET.TO
BNP.TO
LTS.TO (I was a prolific writer that commented on its ridiculously high valuation when it was known as Petrobakken).

I note that Canadian Oil Sands (COS.TO) is trading barely above what it was in June 2012. This is probably the most purest equity play on WTIC possible beyond putting money in USO (not advisable).

Any thoughts? Comments appreciated.

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.

Capitalized vs. Operating expenses

The easiest way of inflating current year earnings to the detriment of future years is to capitalize cash outlays when they should be expended when they are incurred.

The new financial management at Penn West (TSX: PWT) are looking at the degree as to which this has permeated into the balance sheet of the corporation.

The numbers are not extreme, but a change of 20 cents per share on the income statement is significant. There will likely be some sort of re-statement issued at the end of this process that will take a non-cash hit on equity.

Just strictly from a balance sheet perspective this looks like a deep value play, especially if your prognostication on crude believes that prices will rise. Companies like this are not my thing, but this recent accounting crisis has put the value of the firm clearly in low territory.

This is also another indication of how corporate auditors are not as comprehensive as one would believe. In an ideal world, they would be held accountable in addition to the (no longer working with the company) staff that transacted the questionable journal entries.