Cenovus / Sunrise Oil Sand Acquisition – Analysis

Cenovus (TSX: CVE) today announced they are purchasing the remaining 50% interest in the Sunrise oil sands assets for C$600 million plus another C$600 million in contingent consideration, plus a 35% interest in the “Bay du Nord” project in Quebec, a currently undeveloped offshore project.

The contingent consideration is quarterly payments of $2.8 million for every dollar that Western Canadian Select is above CAD$52/barrel, for up to 2 years, and a maximum of C$600 million. Considering that WCS is currently at about CAD$130, this will work out to $220 a quarter. Barring a complete disaster in the oil sands, it is a virtual certainty the entire C$600 million will get paid out.

I have no idea how to value the 35% Bay du Nord project stake and will zero this out for the purposes of the following calculations.

Cenovus made a $56.20 netback in their Q1-2022 oil sands productions. Sunrise, not being the best asset on the planet, is about $15/barrel more expensive to operate and transport, so we will calculate a $41/barrel netback. However, the royalty structure is in pre-payout, compared to post-payout and hence netback will be higher by about $10/barrel. Very crudely (pun intended!) I estimate around $51 netback (estimated to last 7-8 years before the full post-payout rate kicks in). CVE will acquire 25k boe/d, so they are acquiring about $465 million of netback with $1.2 billion spent, or about a 39% return.

This does not assume that CVE will be able to scale up the operation to 60k boe/d as stated in the release, which would add another $186 million/year, or about 15% extra, ignoring the incremental capital costs of the project.

Tax-wise, CVE still has a $17.6 billion shield at the end of 2021, so the impact of income taxes will not kick in for at least a couple years. Even assuming full income taxes and ignoring the extra 10kboe/d production, CVE is purchasing something for a 30% after-tax return in today’s commodity environment. That’s pretty good for shareholders!

The strangle of higher interest rates

Both Canadian and American interest rate expectations have spiked considerably over the past two trading days.

On Wednesday it appears quite likely at this point that the Federal Reserve will raise its rate 75bps from a 0.75-1.00% band to 1.5-1.75% band. There is also an outside shot of a full 1% increase.

More relevantly, however, longer-term rate expectations have continued to creep higher:

Quantitative tightening hasn’t even gone on for two weeks and we are seeing the markets vomit.

It is not much better in Canada either, with long-term rates elevating to levels not seen since before the economic crisis.

With the 5-year bond going up another 20bps today, mortgage rates will surely climb and this is going to kill credit availability. Specifically in Vancouver/Toronto, condominium holders are going to face two ugly decisions – either they continue to incur a deeply negative carrying cost (in relation to the amount of net rental income they can earn) or they will have to take increasingly larger haircut to prices in order to be able to obtain liquidity. There is definitely going to be a short period of time where people will try to get February pricing, but it will effectively be a no-bid market at those prices.

July 13th for the Bank of Canada is increasingly looking like a 75bps raise at this point (to a 2.25% target rate).

These interest rates are still on the low end historically in the pre-2008 history. The reversal of QE and the subsequent financial reverberations are going to crush leveraged finance in all forms, and markets will be seeking US cash as the safe haven (notably not Bitcoin, which is down about 20% as I write this).

The survivors are going to be companies that generate copious amounts of free cash flow with respect to their valuations. De-leveraging is the name of the game. Those with cash – you’ll be getting your opportunities in the next few months.

The next 10% is going to be very difficult

The rules change in a tightening monetary policy environment. We saw shades of this in the second half of 2018 when the US markets started to vomit over QT and increasing interest rates, and to a lesser degree this happened to Canada.

Recall that the S&P 500 in 2019 very roughly averaged price levels that are about 25% below where it is currently trading at. When factoring in monetary debasement, one can surmise that a “2019 neutral” level would be somewhere around 3,500 but this was with much better economic conditions, coupled with a justification for a sky-high P/E ratio due to extremely low interest rate levels. The average 30-year bond yield in 2019 was lower than it is currently trading at. A more realistic level, all things being equal, would be around the 3000-3200 level (20% lower than present).

Fast forward to 2022 and we are seeing shades of late 2018 – although of course the big difference is that in 2018 central banks could reverse course because inflation back then was at a manageable level. The mandate for higher interest rates is omnipresent with the latest CPI print out of the USA at +8.6% and the latest CPI snapshot in Canada will be released in June 22 and indications definitely suggest it will be up there.

What is particularly damaging in Canada is the spike in mortgage rates. This is going to kill credit in the real estate market:

The 5-year fixed rate is the most common form of mortgage, and from June 2017 (2.4%) to June 2022 (4.3%) is a 190bps increase.

What does this mean in reality? Let’s say in June 2017 you took out $1M in credit financing at 2.4%, with typical terms (25-year amortization). At the end of June 2022 you would be sitting at an $845k balance after making $53.2k yearly payments.

You go and renew this $845k balance at 4.3%, for a 20-year amortization, and you will be paying about $59.5k/year for the next five years – about $528/mo out of your pocket.

Credit has gotten much more expensive. People can mitigate this with a variable rate mortgage, but the Bank of Canada has made it crystal clear that short-term rates will be going higher. For how much longer – who knows. There are conceivably scenarios where if central banks can not get a hold of inflation that short-term rates will be going considerably higher than the so-called “neutral” rate target of roughly 3%. If this occurs, variable-rate mortgages will be under increasing stress.

The point of the above exercise is that unless wages increase dramatically, available credit to be dumped into the real estate market is going to be more expensive and this will be depressing the prices of housing going forward. Since construction is a significant component of urban economic activity, this activity will likely be slowing down as a result – once projects complete, that will be it.

The disaster scenario is that unemployment will spike and you start seeing waves of selling due to foreclosures. It is a scenario that is the big fear for Canada’s mortgage insurers (CMHC and formerly Genworth, now Sagen owned by Brookfield) where you start seeing underwater mortgages. The Bank of Canada is clearly looking at these economic scenarios and I do suspect there is an element of a “Macklem put” in play here – the country simply cannot afford to have a mass collapse in real estate pricing.

Negative economic reverberations would hit the commodity markets as well and higher rates will be triggering this. This is going to make equity picking in the commodity market much more trickier than it has been in the past 24 months.

Even if raw commodity prices take a 25% dip from present prices (e.g. spot WTI from $120 to $90, spot natural gas from $9 to $6.75, etc.), most Canadian (edit one day later: forgot to include a very important word here: ‘energy’) equities are still well positioned to make historically large amounts of free cash flows. However, sustaining capital expenditures will inevitably get more expensive and profitability will diminish, albeit will still be ample. There is likely going to be price volatility as the market grapples between the notions of total returns (their total returns will likely be much higher than companies in other sectors), coupled with pricing in a potential future downslope of raw commodity pricing – essentially pricing the walking down of the futures curve. December 2022 oil is $107.50 as I write this, while December 2025 oil is $74.75. Clearly if spot demand is higher, then existing producers are able to claim the surplus and hedging becomes expensive.

However, the capitalization of future profits (as determined by existing market prices) will continue to gyrate. For companies that are actively involved in share repurchases, these dips are probably more welcome opportunities and shareholders will inevitably be staying at least afloat while the rest of the market continues to tank. However, capital appreciation from this point is not going to be easy – most of the returns will be of the total return type. As I illustrated with an earlier post about Birchcliff, I don’t believe that an investor should be banking on share appreciation, but rather they will be receiving a high dividend stream – in the case of BIR, a healthy double-digit return of cash at the current market rate of $11.75. As raw commodity prices fluctuate, you will see this deviate up and down and this will make for a difficult price environment where, as the title says, the next 10% is going to be very difficult. Getting out of debt and holding ample supplies of cash is going to make people feel very comfortable in this environment.

Dynamics of a catastrophic event – LNG terminal explosion

Today, natural gas futures were headed to their 15-year highs when the following happened:

What happened?

Apparently there was an explosion at the Freeport LNG temrinal.

Freeport LNG handles about 2 BCf/d of volume, which is about 1/6ths of the USA’s current export capacity. Let’s assume this is out of commission for a while, which is what the market is pricing until it figures out what is happening (we do not know the severity of this explosion).

The 1-year out natural gas futures curve was relatively unaffected (it dipped about 20 cents and is roughly unchanged for the day).

We work through the logical consequences of a temporary shutdown of 1/6ths of the US LNG capacity. Obviously spot drops due to 2 BCf/d less demand on domestic North American natural gas (the LNG terminals otherwise are pumping it out as quickly as they can export it). Pure gas players (TOU, ARX, PEY, SDE, BIR) get a profit hit depending on their Henry Hub exposure, but this will diffuse out to AECO/Dawn.

One unexpected winner will be crude futures. Reason? With less LNG export capacity, Europe will now face increased LNG prices and they will face substitution decisions (i.e. they will burn crude instead of oil). Crude is up for the day across the curve.

SAGD producers that are net heavy on steam (SU, CVE, MEG) will do better with a lower natural gas price.

Coal is more vulnerable, due to natural gas to coal substitution.

The reverberations are fascinating to watch in the markets, and they are incredibly quick to occur. They are impossible to trade unless if you have eyes and ears everywhere.

This is also an indication of the liquidity capacity of the market if you remove demand – 2 BCf/d is good enough for a 10% drop in the market. Heaven forbid if 2 BCf/d of supply capacity was added, or if demand dropped by 2 BCf/d in the future (say, perhaps due to an economic depression). Events like these give you good information for future expectations.

Why the focus on macroeconomics?

It might be a sign of the times that over the past half year or so I have been less focused as of late on my investment research looking at individual companies, and more about playing the role of “closet macroeconomist”, hence the focus of my posts being mostly about macroeconomics lately.

I am not intentionally trying to hide secrets (although there are a couple picks here and there in the non-oil and gas space that are still sitting on my research queue after passing my initial smell test) but in an environment where my baseline investment criteria is that it can earn 25% free cash flow to enterprise value, what’s the point in looking for other stocks?

The answer of course is there will be a time that fossil fuels will become politically correct once again (perhaps when all the lights and crypto farms shut off) and one will then have to dip into the watchlist bucket for other suitable investment candidates. That said, fossil fuels are still going very strong and hence why bother when the thesis I wrote back in 2020 (roughly summarized as being long anything ‘real’ and avoiding anything ‘financial’) is still very much intact?

The reason for the macro focus is simply because it is increasingly a dominant variable in today’s investing climate. To give an analogy, let’s say your choice was investing in established large cap gold miner X and gold miner Y. Ultimately you can talk about mine reserves, operating practices, all-in sustainable costs, capital structure, and on and on, but the dominant variable is much more simpler – the price of gold.

Likewise, the macro situation is creating a dominant variable environment where if you cannot get on board with the correct solution, it doesn’t matter what else you invest in – for instance, back in November 2021, it did not matter one bit which portfolio component of ARKK you invested in – you would have lost money no matter what. Perhaps the magnitude of loss would have been different had you chosen wisely, but it would have been a loss nonetheless.

The macro focus that requires meticulous attention is monetary policy and energy economics. Both right now are more dominant than ever as we are experiencing ‘the turn’ that has caught people flat-footed (including Covid, and the sudden realization of geopolitical instability in eastern Europe), coupled with an incredible amount of monetary mismanagement and dismissal of energy physics that has all translated into really terrible policy. Playbooks that worked in the past will not be working in the future.

One of these playbooks is a sacred tenant of portfolio management. It states that a correctly managed portfolio will have an equity and bond split, say 60/40. If you are young and want to take more risk, then 70/30 or even 80/20, but the point is there is some bond component. The notion is that when equities fall, bonds will rise, and if you maintain a consistent percentage, you will be able to rebalance and extract better value in the process.

We insert in the new macroeconomic reality where inflation is running hot and fast, and your bond portfolio is still trading at a negative real yield. This means that the bond component of the portfolio is losing purchasing power for the investor and only depends on other people purchasing bonds to keep its capital value in the event of an equity drawdown.

With the Bank of Canada, US Federal Reserve, and soon the EU engaging in quantitative tightening, coupled with increasing yields (that would also be impacted by QT in addition to inflation), bonds are going to be terrible investments if the next logical conclusion comes. What is this?

Continued monetary debasement. Amazingly despite everything, because the US dollar is the last one standing, it still wins by default. For now.

This brings up a rather interesting quandary for most institutional fund managers. You can’t hold cash (real negative yield, not to mention that you are hired as a portfolio manager to deploy cash and not stuff it in your mattress). You can’t hold bonds (take a look at the idiots that bought Austria’s 100 year bond with a 50bps coupon for twice par!). You can’t hold equities (take a look at the S&P, for example) although this is the least worst of the three options. Don’t even get me started on cryptocurrency as an asset class – although I do see that Luna is CAD$0.000101 a piece, so perhaps you want to buy one of these as an inflation hedge.

There is no escape at an institutional level. One workaround has been to shovel money into private assets and real estate and infrastructure, but these asset classes are very sensitive to rate increases although of course they do not mark them to market until it is too late. Private assets are a brilliant way to defer those losses, however!

Interest rates themselves are another matter. There has never been a point in history where we have seen such monetary manipulation to the point where real rates of interest have been driven this low without massive reverberations. The “consensus” scenario is that we’ll get a 50bps rate hike in July and then some more minor tightening before things ‘normalize’ and are back to normal.

But consider that your baseline input to the economy (energy) is at sky-high levels with no real material notions that more capacity is being brought online – what if this input to inflation keeps rising further? Everybody cites ‘demand destruction’, and indeed there will be a point where energy inputs will become so expensive that collectively we will be forced to stop using them, but until that point, we will see the trickle-down (or perhaps rain torrent) effect of these costs getting baked into everything we consume.

Likewise, salaries will be escalating, and inflation will start on its trajectory of a self-fulfilling prophecy – labour costs will rise because of inflation, and inflation will drive up the cost of labour supply. Already in British Columbia, we are seeing the seeds of this with the upcoming strike vote by the main BC Government Union – they are apparently miles apart from the government. This is one of many cases that will be resulting in significant wage increases going forward.

In a recent Bank of Canada speech (one day after the June 1st 50bps rate hike), we had the deputy governor talk about inflation. They’re now now talking about “avoiding entrenchment” of inflation. Note that derivatives of the word “entrench” is like the new “transitory”.

You don’t avoid entrenchment with small steps. You need shock and awe – something that goes beyond letting the market guess whether the next rate increase will be 50bps or 75bps. An example would be having an unplanned rate announcement with a 150bps increase “to get things back to the neutral rate”. The current short-term policy rate of 150bps is still at near-record lows (historically), and still below the ambient level the Bank of Canada had before Covid-19 (which was 175bps). The big mistake that people can make is this natural assumption of the “regression to the mean”, and currently that scenario right now is the bank will raise to 300bps and keep things there.

Consider the scenario where they will need to raise even further, to around 600 to 700bps to achieve the destruction of this “entrenchment”, and figure out the financial consequences. I am not saying this will happen, but it is definitely something that one should keep in their minds going forward – that inflation will be running away, just like how global warming activists claim that an increase in the Earth’s CO2 beyond a threshold point will cause a run-away greenhouse effect. Ask yourself what components of your portfolio get killed in a world where short-term rates are 700bps, we live in an inverted yield curve where the 5-year mortgage rate is 600bps and almost every asset out there is slashed in half. It isn’t pretty – practically everything other than cash loses in such a scenario (yes, including fossil fuels).

I am not entirely sure what is going to happen. Things are incredibly fluid right now, and I continue to remain very cautious. If there is any general prescription I could give to people, it is the following – if you’re leveraged, get at least flat.