Pipestone Energy – Strathcona Resources

Shareholders of Pipestone Energy last Wednesday approved (with a 67/33% yes/no vote) a reverse merger with Strathcona Resources. Strathcona (substantially owned by a private fund) will own 91% of the remaining entity, while Pipestone shareholders will own 9%.

Needless to say the valuation received by Pipestone shareholders was lacklustre (hence describing the minority protest vote). On August 1st, when the reverse merger was announced, the stock traded down 10% to close at $2.42. After the deal with approved, the stock is now at $2.14. It has dramatically unperformed as almost every other oil and gas equity has appreciated considerably since then. Next week they will complete the acquisition and there will be a share consolidation.

Strathcona has assembled a bunch of relatively interesting assets over the past decade. Considering I have owned debt securities of some of the entrails they have devoured, it is something I still keep track of once in awhile, but now they are public I can continue taking a more relevant look at them.

One of them was the acquisition of Pengrowth Energy for $0.05 a share (and the assumption of their not-inconsiderable at the time debt of about $700 million). I had owned Pengrowth’s convertible debentures ages ago (and they were matured at par, pretty much just before the company was running into liquidity issues). An interesting asset was the SAGD heavy project near Lindbergh, but it was relatively inefficient (recently reported steam to oil ratio was around 4), producing around 20k boe/d.

The total estimated production of Strathcona and Pipestone is 185,000 barrels/day, at apparently a $735 million sustained capital spend (this estimate seems a little bit low in my estimation). At US$80 WTI the estimated EBITDA is $2.5 billion. The metrics at the current commodity price structure is relatively favourable. The market cap, at $2.14/share, will be about $6.8 billion and the debt that will get added on will be in excess of $3 billion. Relatively speaking, the valuation is roughly in the ballpark of (a small number of) peers, so paying attention to asset quality and management’s intentions on how to best work with their capital remain to be seen.

One thing is undeniable – Waterous Energy Fund (the private owner of Strathcona Resources) is going to make a fortune on their investment in Pengrowth Energy made back in 2019. They timed the low nearly perfectly (I do not think they could be faulted for not foreseeing Covid-19). That said, there are other companies out there that have proven shareholder-friendly policies and are trading at even better valuations.

REITs cutting distributions

True North REIT (TSX: TNT.un) – down 50% from 0.049/month to 0.02475/month
Slate Office REIT (TSX: SOT.un) – down 70% from 0.0333/month to 0.01/month
Just last Friday – Northwest Healthcare REIT (TSX: NWH.un) – down 55% from 0.80/year to 0.36/year

There’s a few more on the chopping block. I won’t name them here.

The underlying cause is pretty simple – they are unable to raise rents at the rate their interest expenses are rising. Because they typically run at high leverage rates, they are forced to pare back distributions.

Much of the damage is usually done by the point they announce the cut, but because some investors are solely obsessed about distributions and dividends, they will be receiving a nasty capital shock upon such announcements.

World is choking on US government debt

Today in finance we have 30-year government bond yields the highest they’ve been in a long time (early 2011 to be precise):

This yield is a fundamental variable in a lot of risk-free calculations out there. The higher that yield goes, the lower the capitalized asset prices go! After all, if the US Government is going to give you 4.5% a year for 30 years, why should you bother investing in NVidia that is trading at 50 times earnings?

My suspicion, despite all of the dysfunction about the congressional debt limit, is that the world is finally reaching a limit in terms of how much US debt they can swallow.

This doesn’t bode well for Canada either – although our fiscal situation is better than what is going on in the USA, given our economic linkage to the USA we are going to be along for the ride.

There are potential future outcomes where inflation is not contained and rates have to rise further. Already we are seeing the economic stress and strain of 5% short term interest rates. Economically it is akin to a submarine approaching crush depth. If inflation refuses to taper off (just look at the last CPI report and their components), Tiff Macklem (and Jerome Powell) will have to continue plunging the submarine deeper.

One frequently cited counterargument I hear is that by diminishing demand from higher interest rates (people that are choked with debt will have to spend their money servicing debt instead of engaging in discretionary consumption) will have an effect on lowering inflation. This may not necessarily be true considering that it does not factor in the supply side of the argument. For example, in the current Canadian real estate market, demand (based off of sales volume) has definitely tapered lower, but prices have remained relatively high because there has been an equivalent decrease in supply – listings are very low. Currently in that specific market we are at a sort of “Mexican standoff” where there is no volume at the current price.

However, for the overall economy, it appears that non-discretionary components of inflation are continuing to increase in price while discretionary items are being held in check. A great example of this is mobile phone plan pricing – instead of getting 10 gigabytes of data for $40 a year ago, you can now get 20 gigabytes for the same price. That’s a deflation of 50%!

Survival is the name of the game here – look carefully at your portfolio and avoid companies with excessive debt leverage. Keep that cash handy. Finally, the only glimmer of green that I see in the markets today is that of crude oil futures – at US$90/barrel for spot WTI, many of the well-known names out there are pulling in a huge amount of cash flow.

How to tell if your country is in recession

GST collections are a reasonable proxy for overall end-user spending – the metric only excludes zero-rated and excluded items, such as raw groceries and pharmaceuticals and insurance products.

For the first fiscal quarter of the year (April 1 to June 30, 2023), the Government of Canada reported a 3.6% drop in GST collections in comparison to the previous year:

Personal income tax collections are higher (presumably reflecting on higher wages and gross employment) while corporate income tax collections are lower (most certainly a function of large corporation profitability in the oil and gas sector).

The key point of this post, however, is that it appears that spending is slowing. Are people running out of money to spend?

Perhaps the most shocking part of this report is that it shows the government is in a mild surplus position (when calculating revenues minus expenses) but rest assured, the year-end fiscal projection is still for a $40 billion deficit.

Negative amortization mortgages

Rising interest rates are going to break things, and this one in particular (Globe and Mail article on negative amortizing mortgages) is going to be interesting.

Snippets:

BMO disclosed that mortgages worth $32.8-billion were negatively amortizing in the third quarter ended July 31. That is the equivalent of 22 per cent of the bank’s Canadian residential loan book. For the second quarter ended April 30, the total was $28.4-billion, equivalent to 20 per cent of BMO’s loan book.

TD had mortgages worth $45.7-billion negatively amortizing in the third quarter, the equivalent of 18 per cent of its Canadian residential loan book. That was higher than the $39.6-billion, or 16 per cent of its loan book, in the fourth quarter of last year.

…

In this year’s third quarter, CIBC had mortgages worth $49.8-billion, the equivalent of 19 per cent of its Canadian residential loan book, in negative amortization. That was higher than the $44.2-billion, or 17 per cent of its portfolio, in the second quarter, according to its financial results.

It appears about 20% of mortgages presently are negatively amortizing. This is presumably due to the interest component of floating rate mortgages rising coupled with fixed payments being insufficient to pay the interest component. This would not apply to mortgages that have their payments vary with rising interest rates.

What will be even more interesting is when fixed rate mortgages renew. Five years ago the lowest rate you could get was 3.19%. Today this is 5.44%. By definition when people renew their mortgages they will continue amortizing their principal, but many of them will be facing increased payments. For example, somebody taking a $1,000,000 mortgage 5 years ago at 3.19% on a 25-year amortization would have a monthly payment of $4,830/month. If, after five years, they wish to renew the remaining principal (approx. $858k) at 5.44% with a 20-year amortization, that monthly payment goes up to $5,843/month. If they wish to keep their $4,830/month payment, the amortization on renewal goes to 29.6 years!

It is a valid point, however, that negative amortization is meaningless without the specific quantum involved. For instance, if your mortgage is negatively amortizing at 5% a year, while your property value is appreciating 10% a year, you are actually decreasing your loan-to-value ratio over time. This headline may be a little less ominous than it sounds without digging deeper into the data – which sadly was not provided.

The debt party will end very badly when real estate valuations collapse (if they ever do). Given the propensity of the Canadian government to functionally open their borders to anybody interested (especially in the form of student visas), the influx of population has provided an increasing level of demand for real estate on a very slowly rising supply base. As long as this remains the case, absent of any dramatic rise in unemployment, it appears unlikely there will be any deep downward catalysts on residential real estate valuations.