Canadian Energy Resource Fund Commentary Q1 2017

Market Overview

If we had to put a title on this quarter’s energy commentary, it would be: “Canada the Unloved!” The CDN S&P/TSX energy sub index was down 6.2% for the quarter. Digging deeper into the numbers however, the weakness was much worse. Excluding the pipelines and midstream companies from the energy sub index, the remaining 36 oil and gas producer and energy services providers dropped an average of 14 percent. It gets worse! The bottom 18 companies of the 36 dropped anywhere between 15-34%!

In the Portfolio

The Front Street Canadian Energy Resource Fund was off 7.5% during the same period. While the weakness was somewhat widespread, the Fund’s natural gas producers and its energy service stocks were busier giving up some of last year’s gains.

So why the weakness? While there continued to be growing disappointment with America’s naggingly high oil inventories, particularly in the face of OPEC’s curtailments, the larger weight on the cdn energy group this quarter was Trump Administration related, that is, B.A.T. (border adjustment tax) and the potential for a renegotiated NAFTA agreement. While the likelihood of the BAT is seemingly low, the uncertainty sent investors to the exits. Also of note this quarter was the mass exodus of the international energy conglomerates (shell, total, Conoco and chevron) from the CDN energy scene, selling their CDN oil sands operations. As busy as they were exiting the ‘long life’, ‘no-decline’ oil sands, they were equally active tripping over themselves paying exorbitant prices to buy into the Permian shale play in Texas and New Mexico. While new Permian oil wells do come on stream at attractive flow rates, they do however decline very rapidly – 70-80% in their first year of production! We think the multinationals’ exit of the oil sands business to be misguided and will come back and haunt them in the future!

Having said that, there’s no denying the Trump Administration’s is Pro Energy and Anti-Regulatory bents are looking rather attractive compared to Canada’s opposite stances. While the border adjustment tax is a low probability event, we do think that BAT anxiety will remain in full gear until further clarity is provided. In the meantime, the CDN energy patch investment sentiment is about as low as we’ve seen it since the Asian Contagion era (1998-2000). Valuations are 3-5 cash flow multiples lower that their equivalent US peers! Interestingly, our investments continue to do well operationally and are growing nicely in this environment. They’ve become doubly cheaper!

During the quarter, the Fund sold down its Natural Gas producers while adding to its Oiler names. The Fund also added to its Gold weighting during Q1. We remain overweight the energy service providers. Rig activity levels in North America continue to grow every week and have now doubled from their recent lows 12 months ago. Many wells are being drilled but are unable to get fracked as a result of a lack of trained crews. Service providers are now experiencing pricing leverage work their way.

While U.S. oil inventories have remained stubbornly high (and growing) notwithstanding OPEC tight adherence to production cuts, we are witnessing oil inventories decline elsewhere around the world, particularly in places like Latin America. We expect to see greater evidence of declining inventories in the next few quarters. Stay the course.

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The opinions expressed herein reflect those of the individual portfolio manager. These opinions are subject to change at any time based on market or other conditions, and Front Street Capital disclaims any responsibility to update such views. These opinions may differ from those of other portfolio managers or of Front Street Capital as a whole.

These views are for informational purposes only and are not intended to be a forecast of future events, a guarantee of future results or investment advice. All data referenced herein are from sources deemed to be reliable but cannot be guaranteed.

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