Divestor – Page 179 – Canadian Finance, Economics and Fiscal Analysis

For those with nerves of steel – buy oil

Most investors are likely aware that the price of oil has plummeted. This has taken a lot of equities down with it.

This is a very rough statement (some areas are cheaper to mine than others), but it is getting to the point (roughly US$75-ish) where a lot of tight oil (shale) is unprofitable to mine. This is where most of the oil boom from North America has originated. Heavy oil (oil sands) highly depends on where it is mined.

There are geopolitical games being played by OPEC and Saudi Arabia and the rest of the world. Commodities can trade under the marginal cost of extraction for awhile, but not indefinitely – especially in the case of crude oil, there will be demand.

The question is who shuts off the supply first? It will be the most insolvent high-cost producers, and then increasingly the more solvent unprofitable producers until the market supply decreases. Only then will we see oil prices turn around.

I do not believe a downturn in the oil commodity price will be sustainable for a long period of time in light of global demand still being high.

Decreasing capital budgets for 2015 will translate into decreased supply. However, this is not a speedy process. Most tight oil producers require a continual stream of capital to keep production levels stable and so I would guess some time in 2015 you are going to see a very sharp rebound in oil prices once enough supply has been shut off.

There is a cliche that markets go up slowly but crash quickly. With commodities, they go down slowly and rise quickly.

From my 50,000 foot perspective, there seems to be opportunity. I’m going to guess that low prices will persist until the end of this year. I do not see low prices continuing throughout 2015 unless if there is some sort of major global slowdown beyond what we already see in Europe and China (in the latter case, if you can call a decrease from 7% GDP growth to 5% GDP growth a “slowdown” when your GDP is already 9 trillion dollars, then it is a very odd definition of a slowdown!).

Picture yourself as some economic analyst in the People’s Republic of China with a mandate of securing global energy supplies. Right now you’d be licking your lips and looking at the various publicly traded entities out there. Your only fear is having governments refusing takeover offers out of national security concerns.

Broad energy ETFs (which also include refiners) that encompass this category are XLF, and VDE, but the exporation and producer index (XOP) has been significantly more impacted. XOP has an MER of 0.35%. The Canadian equivalent (and this ETF would provide eligible dividends as it would be from Canadian and not American sources) is XEG.TO and this ETF contains the usual list of Canadian energy producers (Suncor, CNQ, etc.) for an MER of 0.6%.

If you’re brave and have nerves of steel, buy oil. I can’t tell whether right now or the next three months or so will provide the lowest price point, but from a historical perspective, it is closer to the bottom than it was a month ago!

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.

Market volatility

Look at the last couple weeks of trading on the S&P 500:

This is a panic down-panic up type chart – especially over the past few days, it resembles a short squeeze more than anything else.

The overall trend in the S&P 500 over the past couple years has been nearly a straight-line up chart:

Is this going to continue?

Normally in the prior market dips you get this “slowly climb the wall of worry” effect, but this time it appears to be different.

Implied volatility continues to be strongly anti-correlated to market price, but is now settling back into the teens again. Will there be another violent outburst?

And finally, 10-year bond yields are still trading below what they were when this whole market calamity started:

I’d be careful. My guess is that we’re going to see some stormy seas over the next couple months. Whatever started this is not likely finished yet.

Genworth MI Q3-2014 preview

Genworth MI (TSX: MIC) is going to report their 3rd quarter earnings on November 6, 2014. I do not expect anything too different than the previous quarter other than the seasonal factor of higher insurance underwriting as the Canadian housing market is more active in the summer.

Specifically, loss ratios are likely to be at significant lows. Q2-2014 reported 12%, which can only be classified as insanely low – Q3-2014 will be low, but probably not as low as that.

Earnings-wise, given their revenue recognition model, they will likely report revenues around the $141 million range and if their typical rate of realization on investment gains continue, should report around a $1.00 EPS level of operating income. Treasury bond yields were down quarter-to-quarter which should result in unrealized gains.

In terms of solvency, the company’s internal target is 220% of minimum capital required (which they state is sufficient for them to survive a severe recession). They reported 230% in Q2-2014, and this will be higher in Q3-2014. It is quite probable they will increase their dividend rate from 35 cents a quarter to a higher number (their track record has consistently lifted dividends in the Q3 of each year), but there is also a possibility of them declaring a special dividend to eliminate the excess capital.

I do not anticipate a share repurchase – management has been relatively diligent at only buying shares at or below book value.

Other than the usual cries of a pending Canadian real estate market crash, the only pending storm clouds for the company appear to be the fact that they might attract public scrutiny for simply being too profitable. While CMHC takes the lion’s share of the mortgage insurance market (and indeed this is a very lucrative industry for the crown corporation), Genworth MI takes the other slice of the market and earns duopoly-type returns for doing so. The party continues until it doesn’t.

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.