Time to Buy Canadian Energy Stocks

Oil and Gas is a Cyclical Business

It’s no secret that oil demand has been demolished by the novel coronavirus and coincident recession, but in my experience the best indicator of supply adjusting to the downside is activity in the oil patch.  In May, the Energy Information Administration reported the fewest oil and natural gas drilling rigs on record working in the United States.

The time to buy into oil and gas companies is when production cuts are underway and the major suppliers are working in tandem to stabilize the supply/demand balance.

BASRA, Iraq, June 14 (Reuters) – Iraq has agreed with major oil companies operating its giant southern oilfields to cut crude production further in June, Iraqi officials working at the fields told Reuters on Sunday.

Largest Oil and Gas Companies in Canada

In August of 2009 Suncor (SU) merged with PetroCanada to become the largest integrated producer in Canada.  The company reported cash flow for the first quarter of 2020 of $0.91 compared to $0.98 in the 1st quarter of 2019.  The company pays a dividend of $0.31 per share.  It’s 52 week price range on the Toronto Stock Exchange is $45.12 – $14.02 and its currently trading just above $24.  I bought this a few weeks ago.

Data by YCharts

The second largest (and my current ‘planning-to-buy’ stock) energy company and the largest ‘independent’ in Canada is Canadian Natural Resources (CNQ). The dividend was actually increased to $0.425 per share – a refreshing departure from so many other industry players who’ve cut their dividends.  Fund flows from operations also covered their capital expenditures. The 52-week range for the stock price is $42.57 – $9.80 and trades near $24 on the TSX.

Data by YCharts

The third company I’d like to discuss is Imperial Oil (IMO on the Toronto Stock Exchange).  Founded in 1880 in Canada, it owns 25% of Syncrude – one of the largest oil sands producers in the world. The integrated oil and gas company is majority (69.6%) owned by ExxonMobil.  Cash flows from operations declined significantly (down 58%) year-over-year, no doubt due to the large portion of their business tied to the costly oil sands. The stock is trading around $23, pays a dividend of 22 cents per share and it’s 52 week range is $37.75 – $10.27.

Data by YCharts

Experience Matters

I’ve been involved in the investment management business in Canada for nearly 40 years and have witnessed the same pattern of Americans investing in the Canadian energy sector over and over again.  Once oil prices have already risen, and the Canadian dollar has strengthened against the USD there is a stampede of US institutional investors buying Canadian oil and gas companies. When US interest in Canadian companies peaked, I would sell the sector outright.  Whenever confronted by a complete lack of foreign investor interest, I would buy.  We are once again in the ‘buy’ zone.

Anecdotally, there are other contrarian indicators that inspire confidence that the time is ripe.  Consider this headline from the Canadian national newspaper (the Globe & Mail, June 12, 2020):

Don’t be too quick to buy TSX energy stocks.

When the press is sufficiently negative, the sellers have sold and tide is about to turn.  Another contrarian indicator that is unique to Canada is the wholesale firing of energy investment analysts. Here’s another headline (also from the Globe & Mail, June 11th, 2020) announcing a move by one of Canada’s leading independent investment dealers.

Canaccord Genuity cuts staff, suspends coverage of 18 energy firms

A lesson I learned over many years as a portfolio manager a resource-based economy is that when things can’t get any worse, they soon get better.

Market Tanks – Great news for some.

I haven’t published for some time now.  Why bother?  The economy was tanking, and the market was rallying.  Made no sense to someone who’s been managing money for 30+ years, so better to say nothing.  However today’s headlines are providing a brief respite:

Dow plunges 1,800 points in worst day since March as coronavirus, economic worries grip market

I must admit the rally was a bit embarrassing.  A number of my special situations (in one of my accounts) have been doing okay, such as West Fraser Timer, Methanex and Suncor but I’ve been waiting for the other shoe to drop in the market to put some money to work.  I couldn’t understand what was motivating all those retail investors chasing stocks they recognize (Amazon, Tesla, and Facebook etc.).  If it makes no sense, I learned long ago not to follow the herd of idiots.  Admittedly, I started to believe I’m the one who’s the idiot.

After a day like today, I feel better.  A strategist I respect who initially predicted a ‘double-bottom’ finally caved the other day, and joined the consensus in believing in a V-shaped recovery.  It’s uncanny how these things occur.  If he’d waited a couple of days, he could have stuck to his original forecast and today might look like a genius.

What should be happening, is the market tanking while the economy begins to recover – as occurred in most cycles I’ve experienced first-hand.  In my other account, I’ve been sitting on cash since before the pandemic; waiting patiently for an entry point (based on good old fashioned fundamental analysis) that I feel comfortable with.  The last one worthy of note was 2009.  Hopefully, my opportunity will present itself in the coming months.

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The roller-coaster stock market.

The market continues to behave like a roller-coaster.  But will this ride ever end?  In the past, the ups and downs of stock prices have always mirrored the ups and downs in earnings, but this relationship seems to have broken down – or has it? The below graph shows (up until December of 2019) how obvious the correlation is between the S&P 500 Index (blue line) and trailing earnings for the index (the orange line).  The initial selloff anticipated a drop in earnings for the 1st Quarter which was only partially impacted by the coronavirus lock-down.  The rock and roll pattern we’ve witnessed of late evidences the uncertainty of how the 2nd Quarter is going to pan out.

Most of the (upside) action in the stock market has been limited to the mega-caps (Microsoft, Apple, Amazon, Alphabet (Google) Facebook etc.) which now account for a substantial part of indices.  We’ve also enjoyed a significant rebound in the energy sector.   But the rest of the economy?

As reported in Institute for Supply Management^®’s (ISM^®) Spring 2020 Semiannual Economic Forecast, released Friday, they project the manufacturing and non-manufacturing sectors to contract this year, with manufacturing revenue forecast to decrease by 10.3 percent and services-sector revenue expected to drop by 10.4 percent. Capital expenditures also are projected to take a hit, and capacity utilization is expected to be down.

The great unknown isn’t really about the next quarter which will be awful, but what the rest of the year will look like in terms of earnings.  Are the mega-caps really immune or just laggards?  The ISM estimate of a decrease in revenues could underestimate what’s in store.  And because corporations are highly leveraged (years of borrowing to buy back their own shares) the decline in earnings will be a serious multiple of the fall in revenues.

Many pundits who expected a double-bottom have changed their tune and now believe we’ve seen the bottom.  It would be great if they are right, but if history is any guide the (revised) consensus, like every consensus should prove mistaken.   It’s sort of like the roller coaster, once you think the scary part of the ride is over, another one sneaks up to test your intestinal fortitude.

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Shopify Issuing Shares? No surprise there!

I’ve seen this movie over and over again.  A stock rages upward, and instead of letting investors simply enjoy the ride the company has to ruin it by issuing (diluting) more shares.  This is just the first volley – expect more of the same from the technology sector that has enjoyed a huge rebound from the bottom.

Just before the next wave of troubles (I can’t say what will cause it, other than history just keeps repeating itself) in any industry that’s become  a darling we witness a flurry of equity issues.  Our most recent (sour) experience was the cannabis industry.  It’s uncanny that just yesterday I suggested the tech group has had enough of a surge to become uninteresting again from a valuation perspective.

I can imagine the discussion in the executive offices:

The stock is over $700, and we’re worth more than the Royal Bank.

What should we do?  The next few quarters could get ugly as our small business customers are likely going out of business.

I know, let’s issue some shares at these ridiculous prices.

Do we need the money?

We might or we might not, but who cares?   Let’s get some anyway.

Yeah, after all we only need to issue 1.85 million shares to raise over a billion bucks.  This craziness can’t last.

To quote the distinguished Som Seif of Purpose Investments: “If I was sitting there last night thinking about Shopify’s price, I would have said to myself they should issue shares at this price because if other people are giving them such a crazy valuation, why not take some money and put it on your balance sheet at a time when cash on your balance sheet is a very valuable thing.” (from BNN Bloomberg News).

It’s depressing how difficult it is to find companies that just want to run their businesses rather than jump on every opportunity to milk investors.

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Time to sell tech stocks? Yes!

On March 25th I suggested it was okay to buy tech stocks, and featured a couple of ETF’s. I did buy at the time, and have enjoyed a 50% return in less than 2 months.  Let’s face it, with bond yields of .70% (10 year US Treasury) it would take many (or in Trump parlance, many many many ) years indeed to earn this doing it the risk-free way.

Why sell when the tech sector is back to what it was before the crisis began? Now that Shopify has a market value larger than the biggest Canadian bank, enough is just enough.  Having lived through the rise and fall of Nortel, Blackberry and more recently Canopy I’ve learned the hard way to take a decent return and look for something new.  Ordinarily it takes longer than a few months, but the times they are a’changing.

I fully understand why investors are enamored by tech, gold and of course the pharma companies.  What else is there?  However there will come a point at which a recovery in the more downtrodden sectors is on the horizon (it will be awhile though, with plenty of disappointing earnings and economic announcements beforehand) and like Warren Buffet, I’d like to have some cash available for that eventuality. (PS I’ve also trimmed my gold weighting).

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Decrease in Consumer Spending Alarm Goes Off.

I’ve hinted many times over the years that the most robust leading indicator is the ISM (Institute for Supply Management) manufacturing index.  Last Friday, the report was – not surprisingly – dismal.  May is likely to be even worse.

We’re also seeing the first (data) signs of the huge impact coronavirus is having on discretionary spending, and it’s not pretty.  Yesterday the ISM published the non-manufacturing (or services) index.  It’s the definitive end of 10 years of growth.

Despite the optimism still embedded in the stock market, Warren Buffett’s reluctance to throw money  at it could prove to be brilliant.  The prospect of a V-shaped recovery seems pretty remote – these leading indicators point to one ugly summer in economic terms and more data will simply mean more disappointment.

Why Warren Buffett’s Moves are Bewildering.

Everyone is confused – He bought a bunch of airlines at their peak, and sold them all (was the normally undaunted investor suddenly in a panic?) at the bottom.  “Fear is the most contagious disease you can imagine…” said Buffett at his annual shareholder meeting.  He also said:

“It all depends on your circumstances, but you shouldn’t buy stocks unless you expect… to hold them for a very extended period of time and are prepared financially and psychologically to hold them,” Buffett explained.

Surprisingly, the one man we thought would be buying the downtrodden airlines when they looked hopeless, was bailing.  I’ve read many (hindsight is great) comments from experts claiming they couldn’t understand why he bought airlines in the first place. After all, its a notoriously volatile industry and hardly one we’d consider his ‘cup-of-tea.’  But sitting on a hoard of cash during a raging bull market, while being constantly questioned (pressured?) about it eventually makes one begin to wonder:  “Am I wrong?”

Step back a few months.  The whole market was (and probably still is) overvalued – some of us even said so in print, most others now claim to have ‘thought so’ but did or said nothing as evidence.

Mr. Buffet said and knew it, but may have felt he had to do something and found the only sector that looked reasonably valued by conventional measures – the airlines were making good money,  the world was jet-setting like never before and their valuation metrics (P/E ratios etc.) were not astronomical.  He is bold enough now to admit he made a mistake and takes full personal responsibility.

What is so bewildering is:

1. He didn’t hold the companies (he’s always insisting he buys companies and not stocks) for the longer term, as we’ve come to expect.
2. We would normally expect him to be buying the more down-and-out companies during a crisis like this.

After all, the same guy bailed out the major US banks during the last financial crisis, and later saved Canada’s mortgage lender Home Capital when they were in dire straits.  Brave moves like these made him and his shareholders lots of money.

I can think of two possible explanations.  One is he too became afraid.  After all, Mr. Buffett is 89 years old, and the ‘longer term’ just isn’t as long anymore.  I don’t mean this in a mean way at all – I too am getting older and my perspective when it comes to ‘time’ has changed meaningfully if not necessarily for the better.  Keeping those airline stocks (even if averaging down) would have been an eyesore for a very long time.

The second explanation I like better.  Perhaps Mr. Buffett (and I would agree) believes things will get much worse before they get better.  Stocks are still too expensive to be interesting, and the global economy continues to shrink.  The cash hoard can be put to even better use now that virtually all industries have been devastated by the lock-down (with perhaps the exceptions like Amazon, grocery stores and divorce lawyers).  No doubt he and his successors will have their pick-of-the-litter in due course.  This explanation is more consistent with his wise words (more than 30 years ago):

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

Now is perhaps the time to offload mistakes, or simply those investments that are marginal and have enough ammo to make bigger better bold moves when the dust really settles.  He’s not so much fearful, but rather getting ready to be greedy.

 

US Energy Self-Sufficient – But for how long?

According to the Energy Information Administration, the US is more than self-sufficient when it comes to energy.  For the first time in a very long time, production of energy (all sources) exceeded consumption in 2019.

What we do know is that much of the production side of the equation has come from shale oil and gas producers who are now having to shut down production or worse (bankrupt) – they weren’t even profitable at much higher oil prices.  Perhaps the conspiracy theory that the Saudis and Russians didn’t disagree about cuts,  but really agreed to simply put the marginal suppliers out of business for both economic and political reasons has legs.

From the Financial Times:

“American production reached almost 13m barrels at the end of 2019 — the third year of increases that allowed the US, on its own, to meet the total additional annual oil needs of an expanding global economy. Since 2008, American oil production has more than doubled.”

There’s no shortage of companies engaging in price wars (or other tactics) in order to take out the competition. In order to control pricing, it’s necessary to control supply. Perhaps OPEC+ wants the rest the world to understand who’s really in charge…and it’s working.  It isn’t just the producers who are hurting, but the infrastructure that supports the industry is collapsing.

“If I go out of business or shut wells it’s not just me,” says the head of one small oil producer, “it’s the five guys who service the wells, truck the oil, lease their trucks — and the community that depends on their tax dollars.”

And there’s also the railroads, pipelines and refineries.  The flip-side is that once supply and pricing get back under control the shares of the surviving companies will rocket.  For those who can wait a couple of years, these stocks should be bought.

Consumer Sentiment – down but still not down enough.

Over many years I’ve marveled at how reliable consumer sentiment has been as a contrarian indicator.  When it reaches rock bottom then the markets, followed by the economy begin to recover from a crisis – whether a recession or financial.  The University of Michigan Index of Consumer Sentiment just came out and is holding relatively steady (just above the 70 level) so far this month.

But as the economic news gets progressively worse, there’s a good chance that consumers will become even more squeamish.  This has been the pattern in previous periods of financial and economic distress.  And the bad news just keeps on coming.

Orders for durable goods sank 14.4% in March largely because of a decline in demand for big-ticket items such as new cars and trucks as the coronavirus swept across the U.S.

The steep drop in bookings last month was the second biggest ever since the government began keeping track in the early 1990s. Orders never even fell that much during the 2007-2009 Great Recession.

A reliable leading indicator is The Industrial Production Index, which fell 5.4 percent in March, as the COVID-19 (coronavirus disease 2019) pandemic led many factories to suspend operations late in the month.  Of course, when the reading for April gets published it will be decidedly much worse. We won’t see a substantial improvement in the economy until this index turns positive again.

If the stock market is the sum total of expectations, then its ‘hanging-in-there’ could simply mean expectations remain overly optimistic for a near term rebound in business activity.  If the reality turns out to be worse than expected, then the markets could head south once again.

If consumer confidence is a contrarian indicator, at what level we expect to see it bottom out?  Based on historical precedence I’d suggest when it gets down to the 60 level we’re at a point where the prospect of recovery is imminent.

Consumer spending is 70% of the US economy, and retail and services account for most of it. We’re in for a wave of disappointing earnings surprises, ugly economic data, sour unemployment reports and a tsunami of bankruptcies before any recovery can be contemplated.  An I’m an optimist.

How bad is it for energy sector? Real bad and getting worse!

When I published “Oil Stocks Should Continue To Be Avoided” on SeekingAlpha.com (March 6th) I was surprised by this comment from a reader:

XOM hasn’t cut their dividend for 37 years. CVX hasn’t cut their dividend for 32 years. This latest supply/demand issue isn’t going to break these companies or cause them to drop their divvies. The stock price drop in major oil is a fabulous gift.

Of course, the prices of the energy giants’ shares did continue to plummet, but as far as I know, the majors mentioned haven’t yet cut their dividends, but many more junior companies have done so; and now the first global energy player has caved.

“In this extraordinary situation, we have decided to reduce the cash dividend for the first quarter 2020 by 67% [to $0.09],” Norway’s Equinor (NYSE:EQNR) said in a statement. While most oil majors have already slashed investments and buybacks, the latest could be a signal of what’s to come from others in the industry, including Royal Dutch Shell (RDS.A, RDS.B), BP (NYSE:BP), Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), Total (NYSE:TOT) and ConocoPhillips (NYSE:COP). (source: seekingalpha.com)

The U.S. Energy Information Administration (EIA) just came out with their weekly update on the demand for oil.  The EIA estimates the decline in petroleum product demand by examining the changes in total product supplied, EIA’s proxy for consumption. This chart shows just how bad the impact of COVID-19 has been and will be:

The good news is the price of gasoline is cheap (and beating down inflation); the bad news is we’re not going anywhere to reap the great savings.