Canadian Energy Update

Here is a quick post on the state of Canadian energy production companies – especially as the federal government continues to destroy the industry. As of September 30, 2020 there are 12 companies listed on the TSX that are over a billion dollars in market capitalization. There are 24 between $100 million and $1 billion, and some of these names are in very bad shape indeed. Also out of these 36 companies, some are TSX listed but have the majority of their operations outside of Canada.

For this post, I will focus on those above $1 billion. Companies that are under this threshold are still invest-able but one has to pay careful attention to whether they will survive or not in the hostile regulatory environment.

If your central thesis is that fossil fuels are going to decline and die in a relatively short time-frame (e.g. 20 years) then you probably won’t want to invest in any of these. Demand destruction will impair pricing and the ability to produce supply will not accrue excess gains to any names.

However, this is not going to be the case from a simple perspective of energy physics (laws of thermodynamics if anybody is interested in studying). Renewable sources do not scale to the magnitudes necessary. It also costs massive amount of up-front investment to implement renewable energy sources. It is relatively easy to ramp up energy usage from 0% to 5%, but above this, it becomes very obvious what the deficiencies are of renewable power sources (California discovered this in the summer). Putting a long story short, the more renewable (intermittent) sources you have on a grid, the better will be for on-demand generation sources – this means either you go with natural gas (fossil fuel!) or hydroelectric (we’re mostly tapped out in North America). Batteries make sense in smaller scale operations but not in state-province level grids. Or you can rely on imports, which just like liquidity during a stock market crash, is generally very expensive or not even there when you need it the most.

With respect to transport fuels, we will classify this as passenger, freight and aviation. For passenger vehicles, we all see Teslas and the like on the road, but the infrastructure required to refine and produce the battery materials to replace a substantial portion of the automobile fleet is still a long ways away. For freight, battery-powered transport automobiles are an illusion due to the requirements of existing freight haulers (you need to be able to transport 80,000 pounds of goods at a long distance and also cannot afford to spend 12 hours at a charging station to refuel).

My opinion will change if nuclear becomes a viable option again for power generation (from a political and cost perspective, not a technical perspective).

Some pithy notes (these are the C$1B+ market cap companies):
SU, CNQ – Clearly will survive and represent playing a very long game. Personally like these much more than the big majors (e.g. XOM, CHV, COP, BP, etc.).
IMO – Majority foreign (US) held (XOM), wonder if they will make an exit
CVE – The best pure-play SAGD oil sands player (maybe to be contaminated by HSE acquisition)
TOU – Spun off another sub, largest of the Canadian NG players, FCF positive
HSE – Soon to be bought by CVE – will be interesting to see how CVE makes more efficient
OVV – Mostly American now, with big major style culture and cost structure (i.e. $$$)
ARX – Second NG/NGL play, FCF positive
PXT – Substantively all Colombia operations, that said their financial profile is quite good relative to price
PSK – Royalty Corp (royalties are not my thing – just buy the futures, although pay attention to price, if they get cheap enough, royalties are typically a better buy)
CNU – Chinese held, illiquid security
VII – Liquids-heavy gasser, FCF positive (barely), a bit debt-heavy

Chemtrade Logistics, or yield investors be very careful

If any of you hold units in Chemtrade Logistics (TSX: CHE.UN), it is quite possible in the mid-term future that the current $0.05/unit per month distribution (which was already reduced from $0.10/unit per month during the Covid crisis) will be chopped down by about a half. It’s not a guarantee that this will happen.

Chemtrade’s underlying businesses are profitable, but the amount of financial leverage they have accumulated over the years is impressively high. Back many years ago, they were trading in the upper teens despite having an effective payout ratio higher than their free cash flow generation. Although the business itself is relatively stable (it is a staple commodity producer of industrial chemicals that are foundational in nature for many industries, similar to Methanex (TSX: MX)), the leverage is probably going to be too high for the banks to get comfortable with extending credit. CHE did receive a relaxation on covenants until 2022, which will give them a couple years to get their financial leverage metrics in the right direction.

In September, they did manage to close the deal on some additional unsecured debt financing (TSX: CHE.DB.F), but it came at a higher cost – a coupon of 8.5% and conversion price of $7.35/unit, when previous issues (when the units were trading at $20/unit) were around 5% coupons and $25-30/unit conversion prices. Needless to say these debentures are well out of the money. The proceeds of the new unsecured convertible debt was used to redeem the near maturity unsecured debt that was set to mature in June 2021.

The total debt is about CAD$812 million in senior bank debt, and CAD$531 million in unsecured convertible debentures, for a total of $1.34 billion in debt capitalization. Looking at the first nine months of this year (which is not typical due to Covid, but reflects the existing reality), after interest expenses and lease payments, the company generated roughly $85 million in cash. A good chunk of this (CAD$55 million) went out the door in unitholder distributions. There’s a couple scenarios that are possible, but the easiest route is to slowly reduce debt by reducing or eliminating the distributions. The unit price will most certainly take a short-term hit, but as the company’s credit profile improves, the equity pricing (currently at a market cap of roughly CAD$450 million) looks cheap, although it is this way right now because of the high magnitude of leverage.

If there is another credit crisis (whether it is induced by the company’s actions or not) that comes along in the next year, you can be sure these units will be cratering, even further than they have already.

I remember people pumping this income trust around $15-$20, citing the high distribution yield. Right now, I don’t see a lot of pumping, and if they do cut distributions again to get the bank debt down, I’ll be closely examining the equity. I do have a small position in one of their debentures.

A pending restructuring – Peabody Energy

I alluded to, but didn’t name Peabody Energy (NYSE: BTU) as the victim in my August 10 post about a pending debt restructuring. Peabody Energy is in one of the most hated sectors, coal mining. They operate thermal and metallurgical mines in Australia, and a large thermal mine in the USA (in the Powder River Basin, Wyoming) which had its own drama with the Federal Trade Commission that I won’t get into the details. Essentially, the plan was to form a 70/30 joint venture with Arch Resources (NYSE: ARCH) to synergize a huge amount of cost savings on their (very cash profitable) thermal coal mining operation. The FTC rejected it, citing anti-trust.

My timing for the exit of Peabody’s 2022 debt was quite poor as in the prevailing 2 months after the post, the debt traded some 30% higher, but I was generally not cognizant of the state of the market (there was quite a bit of speculation embedded in the lead-up to the Powder River Basin decision which I thought was already baked into the bond price, but clearly it was not).

In their last 10-Q, Peabody ramped up the language to state:

While the Company was compliant with the restrictions and covenants under its debt agreements at September 30, 2020, noncompliance with the first lien leverage ratio covenant under the Company’s Credit Agreement (as defined in Note 12. “Long-term Debt”) is probable as of December 31, 2020, if the Company does not successfully take mitigating actions.

But what was really interesting and fascinating from a debt renegotiation perspective is the 8-K that was released which gave a fairly detailed status of the negotiations with the secured creditors, including the 2022 noteholders. Peabody wants to negotiate an extension, but the parties are far, far off (the least of which is that the noteholders want 12%, while Peabody is willing to go up to 7.125%).

Discussion Materials / November 1 resolution / November 4 resolution

I know the last thing you want to do is probably look at more slide decks, but considering that the public rarely gets to see these backroom negotiations, for those finance folks out there, you’ll get a big kick from it.

I do notice today that Interactive Brokers is no longer showing any quotes for the debt. Yesterday the closing quote was bid 36.45 and ask 46, with the last trade being $200k traded at 37. Illiquidity is one of the reasons why I dumped as quickly as I did – you never know when the rug will get pulled from underneath.

Finally – this company violates Sacha’s investing rules on ticker symbols, which is the following: If the ticker symbol has no resemblance to the company’s name, don’t invest.

Going from public to private

A few of these have hit the headlines recently in a relatively short time period:

Genworth MI (TSX: MIC) having their 43% minority interest held by the public acquired by the majority holder Brookfield; this can generally be attributed to a relatively inexpensive valuation if it passes.

Dorel (TSX: DII.A/DII.B) is going private, lead by the managing family. An investor in the COVID-19 bottom would have made an astounding 10x their investment, although at that time it should also be pointed out that their financial position was already quite leveraged (principle: the more dangerous they look, the cheaper they are).

Rocky Mountain Dealerships (TSX: RME) in a management-sponsored takeover of the company with a capital management firm. In general, I’d consider the $7/share offered in relation to the rest of the firm to be a fairly cheap acquisition.

Clearwater Seafoods (TSX: CLR), while not strictly going private, will effectively operate as such under Premium Brands (TSX: PBH) holding half the ownership while the Mi’kMaq First Nations will control the other half of the company. My assumption is the (relatively high) valuation paid has strategic value in light of the First Nations’ fishing rights – squeeze out the competition.

The last three are companies that are generally off the radar of most institutional investors. Makes you wonder if others are brewing – if your obscure company doesn’t get much love from the financial marketplace, why bother staying listed?

2020 Presidential Election Prediction, second episode

I try to keep politics out of this site, except when politics has an impact on the marketplace. As long as this is the case, I’ll continue to comment about politics and this week definitely warrants some comment about it.

I’d like to preface this by explicitly outlining my level of emotional involvement in the presidential election. There is none. Whether Biden, Trump or anybody else wins the presidency, doesn’t matter much to me personally. I’m not like a spectator cheering for my preferred sports team; I’m a detached observer that is trying to predict who will win for the purposes of determining what set of policies will get implemented, and these policies will give certain sectors tailwinds that are worthy of investment, and certain sectors headwinds that you will want to steer clear. Look no further than any natural resource investment in Canada, especially post-Bill C-69, which is the incumbency protection bill for any company with an existing pipeline or natural resource project. Pipeline? Nope, unless if the government nationalizes it! Coal mine expansion? Sorry, you’re toast!

Again, winners and losers come out of any political changes in office. It is not my job to get happy or upset at any particular candidate or party, but rather to figure out what is likely to happen as a consequence and take appropriate action. My prediction of Trump winning is not out of any love for him but how I see it (although I will confess that he is ten times more entertaining to watch than Hillary Clinton or Joe Biden will ever be – it is undeniable he is a truly unique character in politics).

The point of this – some people confuse a prediction of a winner as some sort of endorsement. It is not.

Anyhow, my 2020 prediction was essentially correct. It doesn’t matter that Trump actually wins or loses the electoral votes in the states in question (the relevant ones being Arizona, Michigan, Pennsylvania, North Carolina, Georgia, Florida), the fact that Trump was polling 5-8 points behind most of these states should have made them all easy Democratic states. The real story was totally different. The public polling data was complete garbage (much more so than in a typical Canadian election) and one of the reasons for this was that the polling data was not generated for the purpose of ascertaining the voting outcome, but rather for fundraising. The other that I outlined was that they simply did not capture the composition of the actual people voting in elections.

Right now we have all the media outlets (which all are blinded by their hatred for Trump, which is ironic since the hatred amplified his political persona and elevated him to the presidency) claiming or nearly about to claim (I post this on a very late Thursday evening) that certain states have been won by Joe Biden, bringing him above the 269 electoral vote threshold, which should be sufficient for the presidency. The numbers on the electoral map will indeed show it. Half of the country will cheer thinking that Biden has won the presidency.

The reality, however, is going to be a lot more complex due to how the American electoral system works.

It is the electoral college that votes for a presidency. States approve the electors on the basis of the vote. This process is not automatic.

There will be a mountain of evidence assembled of various non-compliances of the election. This will get appealed up, and will get taken to the Supreme Court. The Supreme Court, despite being stacked with three Trump appointees, will want to wash its hands as thoroughly as possible, but they will give states some options. This is definitely a different scenario than Bush v. Gore – analogies will be made, but this analogy will be inappropriately used.

In the case of Pennsylvania, Georgia, Wisconsin, Arizona and Michigan, the state legislatures are Republican controlled. If the final reported vote margin is within a fraudulent margin provided for by evidence, it appears possible that the state can simply fail to certify the results of the vote and not choose electors. There is some precedent for this in 1864, which notably was in the middle of the civil war, which seems to be an appropriate term of what is going on in the USA right now.

If Biden was already up 300 to something, the remaining states wouldn’t have mattered. But if things are very tight (e.g. within 20 electoral votes), the closeness of the result is going to matter significantly if it is determined that one large state (e.g. Pennsylvania) is deemed to be fraudulent with their handling of mail-in ballots. With 20 electors abstaining, nobody can achieve 270 electoral college votes, and hence the vote for the president becomes a contingent election. It gets kicked to the House of Representatives, and they will have a choice of choosing the top three receivers of electoral college votes. While it is likely to be Trump, there could be a non-Biden, non-Trump elected president as long as there is a faithless elector willing to nominate a potential third person as a compromise president.

If the media claims Biden won, Biden gives his victory speech, and half the American public believes he won, and on the other side you have claims of election fraud, and also states clearing the way to (legally) not certifying the results or sending electors to Washington, DC, it amounts to a very contentious scenario which is probably to involve a lot of social unrest, especially on the Democratic side.

At one point after the election, British gambling sites were offering 15:1 odds on Trump winning the presidency given what we have seen numbers-wise. While I would not take such a bet simply because they would probably close it in Biden’s favour once the victory speech is given, I would not count Trump’s chances as being over yet. There is a very viable scenario where it becomes a contingent election, and then you’ll have to dust off the 1824 playbook, where this last occurred for presidency. This is the year 2020, and it is most certainly a year for strange things. Keep your mind open to the possibility.

With respect to the impact on the markets, the orgy of buying that we have seen in the past three days has been immense, but extreme caution is warranted in my opinion. This is not over at all.