Enbridge Line 5 – Canadian oil and gas

There appears to be a win-win situation coming for Canadian oil and gas companies.

I normally avoid politics on this site except when it intersects the financial markets, and this is one of those cases.

While publicly pooh-poohing the construction of hydrocarbon pipelines to placate their environmentalist voter base, the current federal government took actions to effectively kill the “northern gateway” pipeline and “energy east”, both of which were to provide egress from the Alberta/Saskatchewan production areas. In particular, Energy East would have solved the problem of how Ontario and Quebec could source an energy supply strictly through Canadian territory (something they are not doing presently!). Bill C-69 of the previous parliament (the enactment of the “Impact Assessment Act”) was the spike into the heart of further development, which allows the federal government to drag any development through light-years of muskeg bureaucracy for approval – unless if such a project receives its royal blessing. Indeed, it had exactly this effect.

However, our current government has also displayed some very glaring inconsistencies in their approaches to many things. I’ll leave most of it for the opposition parties to pounce on, but one of them has been the acquisition and subsequent ongoing construction of the TMX pipeline from Kinder Morgan – an opportunity for graft that even the Liberals couldn’t give up. Most people associate the TMX purchase with the expansion of the pipeline, but many less are aware there is a fully functional pipeline already in place (which, if you read Kinder Morgan Canada’s prior financial statements, generated a ton of cash flow).

To the present day, the biggest piece of hypocrisy has been the reaction to the governor of Michigan threatening to shut down Enbridge Line 5. Instead of cheering on the Michigan governor for her bold stance on reducing evil carbon emissions associated with the transportation of fossil fuels, especially in a potentially destructive manner that would spill oil inside the Great Lakes, the current government has shown grave concern for the shutdown of Line 5. Since Line 5 supplies over half of the raw fossil fuel product for Ontario and Quebec, a shutdown of this pipeline would have catastrophic economic consequences for the region.

Because of the regional effects (Alberta and Saskatchewan are a political wasteland for the Liberals and hence they will never lift a pinky finger to do anything beneficial for the region that won’t also benefit their power base of Ontario or Quebec), this is why the Liberals are screaming foul and suddenly the continued operation of an oil pipeline becomes paramount.

Enbridge said it won’t stop the pipeline unless if ordered to by a judge.

However, on the backs of everybody’s minds (especially those in Alberta and even those in Enbridge itself), I think there is a significant segment that actually want the pipeline to be shut down, at least for a month or two when it will become glaringly obvious that there is indeed a connection between the smooth functioning of hydrocarbons and people’s everyday lives.

It is an interesting political calculation – while Enbridge would lose short-term cash flow if they shut down Line 5, the pain dished on everybody (on both sides of the border – Line 5 also services a good deal of the American side’s fossil fuel needs in that region) would be quite the marketing lesson. Canadian producers as well would have to scramble to deal with the storage and transport situation (and oil-on-rail would get a temporary kick).

So what is this win-win I’m talking about?

After this debacle, it will be really difficult for the Liberal government to talk trash oil pipelines. Only the NDP and Bloc can remain ‘ideologically pure’ on the matter and maintain an opposition to it.

If there is a disruption in Line 5, Canadian oil producers will take a short-term hit, but this would be transitory. If there is no disruption on Line 5, the message is still intact – even southern Ontario and Quebec need oil to function – it’s just a question of where they’re going to get it from.

The completion of the construction of Enbridge Line 3 in Minnesota (estimated Q4-2021) and TMX (est. Q4-2022), will bode well on this front for Canadian oil. There’s still a US$13 or so differential between West Texas Intermediate and Western Canadian Select, and Canadian producers (which are already very profitable at current WTIC levels) will be able to make even more – and so will the Albertan government, which makes a pretty penny out of the royalties coming out of the oil sands.

Buying is easy, selling is not – Canfor

There’s a great discussion on portfolio diversification between stusclues and Rod in the previous post. I’m appreciative of the time it takes to write these things and for the shared perspective and respect for differences. I was wondering if I was on the internet for a moment.

Going to the title of this post, I have always found the timing of my buying to be a lot better than my selling. The execution of my selling over the past decade or so has been mediocre, to the point where I’ve given it a bit of revision over the years. In general, my problem has been that I have been too eager to sell. I typically buy stocks that are considered to be ‘value’, and when the market realizes it, it tends to over-swing in the opposite direction and I’ve been trying to get a bit better at ‘playing the pendulum’. There have been failures and successes, but for example, in the case of Genworth MI, I probably bailed out a little too early and left some money that I probably shouldn’t have (especially those monstrous special dividends).

Still, one cannot be expected to claim every penny of upside, especially when looking at a stock in retrospect. It is nearly impossible to time the top, as well as being able to time the bottom. A lot of value is captured being directionally correct and not necessarily buying at the low. Also, a lot of value is captured in identifying when the basis for taking the position in the first place was wrong and taking an early small loss instead of a larger one. Finally, if an alternative position poses a better risk/reward, there may be value in diversifying the less attractive alternative – 2020 was rife with sales that today look stupid, but the transaction spreadsheet doesn’t show what was bought in substitution for those sales at that particular time (almost anything sold between March 2020 to May 2020 looked like a bad sale, unless if you take it in consideration with what was purchased at the same time).

Applying these general principles, I have recently decided to bail out my (very small) positions in Canfor (TSX: CFP) and Western Forest (TSX: WEF). These positions were tiny and taken during the Covid onslaught (there was just too much other stuff going on for me to pay more attention), but percentage-wise they were well above a 100% gain. I’ve redeployed the proceeds to companies that are exposed to crude oil prices.

The lumber commodity has been on a huge tear over the past month. The following is a chart of the July lumber futures, and note that the step-up is because on many days the future contract has been locked limit-up:

For contrast, this is the 40 year history of the commodity:

I could only imagine what it was like to be a short seller of the futures over the past month (noting that the 925 price level was already at all-time highs!).

Correspondingly, lumber companies have skyrocketed during Covid. This includes CFP, WEF, WFG, IFP.

I will talk more about Canfor. They are 51% owned by a Jimmy Pattison company (his company also controls Westshore (TSX: WTE)). They were notably in the news in 2019 (pre-Covid) when they tried to take over the 49% minority stake at CAD$16/share. This was a typical Jimmy masterstroke – if it actually passed! The vote failed to meet the passing threshold – barely. Notably, one of the directors, Barbara Hislop, who was a descendant of one of the original founders of Canfor (in addition to working her ranks up the company over a few decades herself), was against the deal. She was the sole director to ‘abstain’ from the board of directors’ vote to recommend selling out at $16/share. That ‘trade’ to not divest saved her many millions of dollars – going into 2021 she had 1.3 million shares of Canfor and has subsequently dumped nearly half of them for around $30 a piece. Talk about vindication.

It’s easy to look at this in retrospect, but even then, Canfor got as low as $6.11 during the pits of the Covid crisis. The trade to not sell out at $16 was looking bad for some time.

In the last quarter, Canfor reported a net income of $3.42/share. Annualized that’s $13.68/share, or about 2.4x earnings at the current trading price of $33. Needless to say, you are correct in questioning my mental sanity when I am selling equity at 2.4x annualized earnings. Didn’t I talk about selling out too early at the beginning of this post?

The reason for this is that lumber is very cyclical. There are boom and bust periods. Right now is the “category 5 hurricane” confluence of events that is triggering a massive demand-supply imbalance and we are in the second phase of that storm where the eye of the hurricane has passed and we are once again facing the winds. Putting a long story short, when Covid started, the assumption that wood executives made was to clear out inventory because the economy would crash and construction would come to a halt. Precisely the opposite happened (everybody decided it was a great time to start building your own deck) and we are seeing the reverberation of those March 2020 decisions today. Now we see 4’x8′ OSB plywood selling at $60/sheet at Home Depot and anything wood-based is insanely expensive.

Certain construction projects must be completed on a timeline – developers generally can’t say “forget it, I’ll wait until lumber gets cheaper to do this project” – there are running timelines that can’t be altered. Discretionary projects, however, will be delayed and this will create its own residual demand which will add to future prices – hence the January 2022 lumber futures are at around $1100. But there will be a point where the demand destruction will kick in, and lumber will hit some regression to the long-time average.

In the meantime, the surviving lumber companies will be repairing their balance sheets and prepare for a day with less profitability than present. Currently, they are pumping out lumber as quickly as they can make it.

In addition to Barbara Hislop selling out, I note that a week ago Brookfield Asset Management dumped a massive stake in West Fraser Timber. While I am not a “follow the leader” type investor, I generally do have respect for Brookfield’s investment decisions.

In terms of the market dynamics, my gut instinct says that now is a good time to cash out. Everything is rosy. It feels terrible to sell out at 2.4x and I am probably leaving 10-20% of upside, but I’m punching out the clock right now. If I had a larger position, I’d get a little more fancy and sell a chunk of it with every few percent of share appreciation (this indeed would capture more of the upside if it were to occur), but I just want this trade out of my mind to preserve my mental bandwidth for other things.

A good primer on portfolio positioning, concentration and measurement

Horizon Kinetics’ 1st quarter commentary has an excellent primer on “On Concentrated Positions, “Locking in Profits” and “Trimming”” which contains sage wisdom, well worth reading (pages 2-6).

When trying to summarize my own investment strategies in a sentence, it always amounts to maximizing the reward/risk ratio (or minimizing the risk/reward ratio). Most laymen when hearing this think it means trying to operate a conservative-as-possible portfolio, but it doesn’t preclude really swinging the bat for a home run now and then at the risk of a strikeout. However, when going into detail as to what exactly entails ‘reward’ and ‘risk’, I end up sounding like a total flake simply because my investment style is to be as amorphous as possible dealing with the cross-section of the highest probability of what I believe I know (e.g. I can’t know everything, I don’t know most of everything, I know a lot of what I do not know, and I don’t necessarily know what I think I know!) and where I think things are going in the grand scheme, and having political experience helps with this. Markets inevitably are human-driven, with all of our psychological traits deeply embedded despite most of the actual trading being driven by human-written yet computer-executed algorithms.

It is always disturbing to me that the performance I have generated over the past 15 years or so has just could have (Sacha’s note: In the original posting, I forgot to include these two words which materially alters this sentence!) been the result of dumb luck. I’d like to think otherwise, but I can’t rule it out. One great and bad thing about an “amorphous” investing strategy is you can’t backtest it to measure how much alpha you truly generate. But I do like the “if I went into a coma for the past X years, would my portfolio be better off today or had I not slipped into the coma” test, whereby you can measure your performance against yourself rather than some arbitrary index. For instance, all of us have underperformed the bitcoin index over the past decade.

If I were to characterize the markets currently, it is pretty clear that things have stabilized after Covid-19 and this is going to end up muting overall returns going forward. Q2-Q4 in 2020 was a bountiful time where farmlands were fertile, and today the crops are growing, but the harvest time is coming very soon. I’m guessing that as the more youthful participants in the markets slowly get their accounts liquidated (through SPACs, junk crypto and the like), that the remaining competitors in the market will be much more sharper with their pricings. The continuing gap of passive vs. active (another topic that Horizon has written about extensively in the past) will also be exploitable going forward.

Parabolic lumber

Lumber has gone nuts, especially in relation to its ambient trend over history.

Since 1978 we have the following (nominal) pricing data:

And in the past year:

Similar to crypto, nothing shows proof of work more than a sawed 2″x4″x8′ stick of wood available at Home Depot!

Not surprisingly, given the completely out-of-history price rise in lumber pricing (right up there with government bond pricing), we have seen lumber producers skyrocket in price from their Covid lows. The previous rise up in 2018 also caused a spike in lumber producers, but this time the prices are even much higher.

However, lumber is like most other commodity markets that are highly cyclical – I suspect pricing is at the point where there will be an element of demand destruction and when this occurs, watch out below. It’ll probably happen in 2021 when the current backlog of “must-construct” projects abates and supply continues to stream in.

The times are good right now – lumber companies will be posting insanely high profit numbers in Q1 and Q2, but the question remains how sustained this massive commodity boom will be. The phrase “leaving the party while people are still drinking the hard liquor” seems apt – it seems so contradictory, but you want to unload your commodity shares at a point where the historical price to earnings is the lowest (typically a mid-single digit). The market has a very good sense of being able to detect when the commodity company has reached its peak profit.

Bye-bye FLIR

I unloaded my FLIR (Nasdaq: FLIR) today at US$58.25/share. Past 10 year chart for reference before the company disappears this quarter:

I’ve been stalking this company for ages. I originally did a very short post on it from July 2011, but never got around to purchasing the stock until the Covid crisis in April 2020.

I wrote about the Teledyne acquisition here which occurred at the beginning of the new year.

I am not typically a large-cap S&P 500 company investor. I make rare exceptions now and then, but for the most part I prefer the smallcap space. FLIR investors will receive 0.0718 shares of Teledyne per FLIR share and US$28 in cash. Teledyne has had an excellent track history of integration acquisitions, although their style of acquisitions have been bolt-on and tuck-ins, and FLIR is a mammoth acquisition for them, the largest in their history. I don’t know if they can execute, although strategically given their product portfolio, it makes sense. Financially, TDY is expensive, but they are also in a business domain that is relatively stable and should continue producing stable cash flows going forward. They will also be a positive recipient of passive index money from the S&P 500 (a larger fraction given how their market capitalization will increase post-merger). But that said, they are too large for me, and hence my decision to eliminate them from my portfolio. I paid about a 30 cent merger arbitrage spread (or about 0.5%) which worked out much better than Atlantic Power!

There few decent alternatives for re-investing at the moment. I am feeling quite conflicted about things in the market, so I continue to reduce exposure.