Commentary

Energy Q1 2016

04/01/2016

Energy Overview

Norm Lamarche & Craig Porter

Had Rip Van Winkle gone to sleep on December 31, 2015 only to wake up on April 1, 2016 and read his stock quotes, he might have walked away thinking that the first quarter of 2016 had brought back some normalcy! For the first quarter of 2016, the Canadian S&P/TSX Composite Index was up a respectable 4.5%, while in the U.S., the S&P 500 Index finished the quarter up 1.35%.* In commodities, the WTI (West Texas Intermediate) spot price finished the quarter up 3.5%, copper finished the period up approximately 2%, and the U.S. Energy Producers Index (EPX) finished the period up 3.2%.

After having caught up with all of his stock quotes, Rip would have had the impression that the period was good, but largely boring; and he may even have been tempted to go back to sleep for another 3 months. For the rest of us, the first quarter was anything but normal.

Commodity markets began the year where the previous one had left off – lower. After falling by 18% in the final quarter of 2015, WTI continued its rapid descent, dropping a further 30% (to USD $26/barrel) by February 11. Share prices of energy companies followed suit. In the U.S., the EPX was down almost 30% towards the end of February and, in Canada, the story was much the same. More heavily indebted companies were harshly punished. Energy sector pain spread into other sectors, too. Debt market concerns dragged on the returns of banking companies exposed to energy. In fact, capital markets globally were under severe duress.

The once powerful relationship between falling oil prices and rising stock markets was turned on its head. Normally, weak energy prices empower the consumer, freeing up more disposable income and propelling economic activity higher. Not, however, in the first quarter of 2016! Overriding concerns about debt markets, bank exposures and the precarious economic well-being of energy nations turned a negative relationship between oil and capital markets into a positive one. What’s bad for oil was now bad for the global economy and its capital markets. Some pundits argue that the weak global economy is creating weaker demand for oil – resulting in weaker energy prices. That would make sense but for the fact that global oil demand is growing rapidly.

As the first quarter wore on, resurging oil prices not only propelled energy shares higher, but helped to propel global capital markets along with it. Oil prices rebounded in March on evidence that oil supply was beginning to drop in America and on increased speculation that OPEC would consider a production freeze. WTI finished the quarter up, but natural gas didn’t fare as well, dropping 16%. North America experienced one the warmest winters on record, sharply reducing heating demand. The U.S.-based EPX finished the period in positive territory, after being down as much as 30% earlier in February. In Canada, the S&P/TSX Capped Energy Index finished up 7%, but the performance within sub-sectors was a mixed bag.

Heading into the second quarter, there is reason to be constructive, from both supply and demand perspectives. Demand for oil continues to benefit from lower energy prices. In the U.S., the Department of Transportation revealed that Americans drove 241 billion miles in January 2016, a 2% increase from the previous year, (you can thank lower gas prices and rising sales of SUVs and trucks). In addition, January 2015 mileage was up a stunning 4.6% above January 2014. Notwithstanding the recurring negative headlines about weaker demand from non-OECD countries, oil demand continues to grow in China as a result of rising auto sales. Like China, India is becoming a larger net importer of energy, with many believing India will overtake China as the most important source of demand growth for oil.

In terms of oil supply, it’s a mixed bag. For the greater non-OPEC supply (65% of world production), there is growing evidence of falling production. In the U.S., oil production is now down about 700,000 barrels/day since recent peaks, with production declines seemingly accelerating. The same can be said in Latin America and North Sea. OPEC continues to be the wildcard. Most (if not all) OPEC members are operating at full capacity, and have been increasing production over the past two years in search of greater market share.

OPEC members are set to meet in early April to discuss a possible freeze – with or without Iran. It seems to us that the only reason OPEC members are meeting is because of the precarious nature of their own economic health. As we’ve written about countless time before, many OPEC nations have tenuous economies and require higher oil prices. We contend that OPEC is not looking to drive prices much higher; rather, their goal is to protect the bottom. Their goal is to prevent the long-lead, high-cost projects from ever being built. In the long run, an OPEC accord won’t even matter, as the unprecedented three-year consecutive capital spending cuts continue to take hold and drive non-OPEC production lower. Rig activity is down dramatically globally.

Front Street Special Opportunities Class

The Front Street Special Opportunities Class finished the period up 7.26%. Helping the fund along in the first quarter were Arizona Star, Spartan and Bankers’ Petroleum, while Granite Oil, Pine Cliff and Western Energy Services weighed on the portfolio. The Fund had a few positions subject to takeovers, that is, Bankers Petroleum and Boulder Energy.

The portfolio is invested in companies that are both low cost and have clean balance sheets, a combination that has served well defensively during the market rout. That same combination will also serve the portfolio well as commodities begin to recover, as these companies will be “first responders” - the first to ramp up capital spending and growth.

Front Street Growth Fund/Front Street Growth Class

The Front Street Growth Fund finished the period up 8.5%. Significant contributors in the first quarter included TORC, Tourmaline and Arizona Star. Conversely, Whitecap, Trinidad Drilling and Pheonix Drilling were all detractors over the period.

The portfolio is invested in companies that are both low cost and have clean balance sheets, a combination that has served well defensively during the market rout. That same combination will also serve the portfolio well as commodities begin to recover, as these companies will be “first responders” - the first to ramp up capital spending and growth.

Front Street Resource Growth & Income Class

Although the resource sector has been quite volatile to start 2016, the Front Street Resource Growth & Income Class has performed well, and was up over 7.5% year-to-date. If you only looked at the start and end prices for the quarter, you might assume oil was fairly flat, around U.S.$37-38 per barrel of West Texas Intermediate (WTI) oil. However, during those three short months, it had a number of wild swings, trading as low as $26 and as high as $42. Although production remains at very high levels around the globe, demand growth seems to be keeping up. Investors are hoping that OPEC will come to some sort of agreement to limit production growth at their upcoming April meeting. We are not confident that anything much will come of the meeting, or that one could even trust any production quota promises that might be made, as history has shown that most countries cheated on quotas agreed to in previous OPEC agreements.

We anticipate a rebound in oil prices resulting from a drop in non-OPEC production. On average, producers in this group cut capital spending by 25% in 2015, with cuts of a similar scale planned in 2016. When you cut spending on drilling by close to half over two years, a significant decline in production levels will follow. We should see the effects throughout 2016. At present, the Fund has no exposure to energy service companies, as we foresee another three to six months of pressure on their earnings due to large cutbacks in capital spending. The price of natural gas, especially in Western Canada, has been very weak on the back of significant storage levels, brought about by low heating demand in the warmer-than-usual winter we just experienced. The Fund has minimal exposure to pure gas producers. That will likely change through the summer months, as we like their longer-term fundamentals, including strong demand from electrical utilities, and the likelihood of lower production as capital expenditure cuts kick in.

The dividend model which a number of oil and gas companies adopted in recent years has been failing many in the current low price environment. With an oil price in the mid-$30 per barrel range, many companies are struggling to maintain production levels and pay a dividend, all within the confines of current cash flow. This leads companies to follow one of two paths: either take on debt to help pay the dividend, or slash the dividend to a manageable level. Most companies have chosen slashed dividends to remain viable, leading to sell offs in their shares from investors seeking higher yields. We tend to own the lower-cost producers like TORC, ARC and Bonterra, who can still follow the dividend model in a low oil price environment. This has led us to seek out other areas for yield, including investments in the power, chemical and utility sectors, until the price of oil recovers further.

The Fund’s performance was helped by its holding in Nexgen Energy, a company that has discovered what appears to be a world class uranium deposit in northern Saskatchewan. Although the company had been putting out exceptional drill results, it was an independent resource estimate, well above street expectations, that sent the company’s shares 143% higher in the quarter.

The Fund also benefited from its exposure to the gold sector, as the price of bullion is up 16% year-to-date. The price rose as investors looked for a store of value in a world where negative interest rates have crept into several countries. Currently, there is over $7 trillion of sovereign debt that trades with a negative yield, forcing people to look for alternative investments that won’t guarantee a negative outcome. Seasonally, gold typically has a strong start to the year, before pulling back in spring, then having a late summer rally. We’ve reduced the Fund’s gold exposure to around 10% from a high of 20% earlier in the year. We’ll continue to monitor interest rates, the global economy, and the value of the U.S. dollar for clues to adjust our gold weighting.

Although the sector didn’t get off to a strong start in 2016, we still maintain our exposure to the forestry and lumber area. The price of lumber was strengthening as the quarter ended on stronger house construction data coming out of the U.S. Moreover, even though the Canadian dollar rallied recently, it still remains well below levels seen throughout most of the past decade, benefiting Canadian lumber producers who sell into the States.

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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.

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