Energy Q3 2016
Norm Lamarche & Craig Porter
Stocks continued to climb during the third quarter of 2016, posting solid results. The U.K. vote to exit the European Union (“Brexit”), weak global economic data, a tightening in the U.S. presidential race along with growing tensions between Russian-American relations reinforced the likelihood that interest rates would stay “lower for longer”. The low ( to negative) interest rates globally continue to provide fuel for asset prices. During the third quarter, the S&P/TSX Composite Index advanced +4.7%, led by information technology, industrials and a rebounding health care sector. Weakness came from the real estate and materials sectors.
Commodities were generally flat or down over the period, although base metals exhibited some strength, particularly metallurgical coal. In the energy complex, the West Texas Intermediate (“WTI”) oil price bounced around the low-to-high $40’s per barrel, ending the quarter largely unchanged from where it began, at approximately U.S.$48 per barrel. Natural gas ended the period down about -2% quarter over quarter.
In late September, OPEC surprised the markets with a proposed production cutback. While the details are sparse, the hope is that it would be ratified at its upcoming November 30 meeting. For any agreement to be successful, it would need to make allowances for production growth in Iran, and for energy nations that have had recent production disruptions (Libya, Nigeria, etc.). The onus would then rest on the fewer, stronger OPEC producers (Saudis, Kuwait, UAE, etc.) to bear the bulk of the cuts. Russian participation would likely be required for a successful deal to take place (despite the fact that Russia is not an OPEC member). The market’s initial reaction has been positive to date, but we’ll have to wait and see what transpires, as historically, individual members have cheated on their quota levels.
We have long contended that’s OPEC’s ability to control prices has been significantly weakened by North America’s shale revolution, and any attempt by OPEC would only be aimed at “protecting the bottom”. The fact that OPEC (and the Russians) are even contemplating a coordinated reduction is an indication of the pain currently being experienced in this low oil price environment. Outside of OPEC, production has been declining, with the U.S. seeing oil production fall over one million barrels per day over the last year. We’ve also seen global demand continue to increase with both China and India significantly increasing consumption. While skeptical of a successful OPEC deal, we remain positive on the energy group as a whole, as there continues to be insufficient capital spending globally to offset natural production declines, and to meet growing global demand.
For the third quarter 2016, the Front Street Special Opportunities Class rose +10.47%. Contributing to performance were the fund’s base metals holdings, which added +610 basis points (“bps”), while the natural gas producers, precious metals, and oil producers added +517 bps, +94 bps and +59 bps. The energy service providers cost the fund -233 bps during the period.
The fund was busy taking profits from its base and precious metals positions while adding to its energy services segment. With oil prices creeping above $50 per barrel and natural gas prices solidly above $3 per Mcf, North American energy producers have begun to increase capital spending into their best (low cost and highest return) drilling prospects. The energy services segment should begin to benefit from these growing activities.
For the third quarter 2016, the Front Street Growth Fund rose +10.03%. Contributing to its performance were the base metals (+578 bps), natural gas producers (+429 bps), oil producers (-50 bps), energy services (+20 bps) and the paper forest (+26 bps). The fund took profits in its base metals, trimming some its oil producers, while adding to the gas-related energy producers and energy services providers.
Growing exposure to the natural gas segment paid off in the third quarter and, we suspect, the group can continue to perform well over the next 12 months as we enter the winter heating season. The record-setting high North American inventories posted at the end of last year’s warm winter has largely been whittled down as a result of this year’s warm summer, growing exports to Mexico and LNG exports out of the U.S.
Hopeful news from OPEC in September helped the TSX Capped Energy Index rise +5.5% for the quarter. We continue to like solid, dividend-paying companies like TORC Oil & Gas, Whitecap and Vermilion, which have been able to maintain their balance sheets during the downturn, and will now likely ramp up capital expenditures with a higher oil price environment.
After hitting cyclical lows last winter, natural gas prices have almost doubled into the end of the quarter, buoyed by declining supply and strong demand. In the U.S., we came out of last year’s warm winter with record levels of gas in storage, but have since eaten through this large inventory and appear to be near normal levels entering this winter. Exploration for gas in the U.S. remains limited, easing concerns of new supply. In Canada, we have higher inventories as infrastructure bottlenecks and competition from U.S. supplies have hurt pricing. To compete domestically you must have significantly lower finding and developing costs than your competitors. It also helps if your gas contains other energy liquids, which trade at a much higher premium than natural gas. Two such companies in the portfolio that meet these criteria are Tourmaline and Seven Generations. Both companies have excelled at finding high-value gas, while driving their operating costs down to levels unheard of in the last cycle, leading to share price increases of +60% and +134% respectively, year to date.
With the rebound in the price of oil from its earlier lows, interest returned to the energy services sector. These are the companies that drill, frac and complete wells. It is felt that the third quarter was likely the trough in the cycle for these companies as drilling activity will likely ramp up as oil gets over U.S.$50 per barrel. One factor that may hamper the rebound will be the manpower required to bring additional equipment back on-stream. Many of the skilled workers who were previously employed in the sector left during the last downturn, and have gone to other provinces seeking more stable work. With increased demand, this labour shortage could lead to a quicker rebound in pricing. We are increasing our exposure to the sector in expectations of a revenue rebound out into 2017.
We have started to reduce our exposure to the utilities sector. Although they have been stable, long-term dividend-paying companies, there currently is a rotation out of the sector on fears of interest rate hikes. Since the industry is capital intensive and financed with debt, investors have been selling on the consensus view that the U.S. Federal Reserve will raise interest rates in December. If there is a significant, sustained pull-back, we would look to re-enter these stocks, as many companies are in regulated sectors, where they can pass on interest rate increases after government review.
Although the price of gold was fairly stable over the quarter above U.S.$1,300 per ounce, gold stocks were off sharply after peaking in mid-August. Gold typically trades in an inverse relation to the U.S. dollar, and with the strength in the greenback, investors feared further weakness in bullion and sold the miners. After having gone through their typical summer rally, we reduced exposure to the sector. The Fund has about a 9% weighting in the precious metals sector, down from 20% earlier in the year. We will maintain some exposure to the sector as a number of upcoming events could provide stimulus to gold, including the U.S. presidential election, European banking issues (Deutsche Bank), political risk in the Middle East and further clarity on the consequences of June’s Brexit vote.
We had previously had little exposure to the base metals sector, seeing little economic reasoning to hold them. However, during the quarter, a number of positive factors rose that have caused us to increase our exposure. While we don’t expect a commodity super-cycle, as seen a decade ago, where all commodities rise, we do see certain metals showing positive fundamentals. Numerous zinc mine shut downs have led to upside in that metal. Strong demand for metallurgical coal, used to make steel, has caused prices to more than double in the last three months. We’ve also seen manufacturing data in China pick up, stabilizing at two-year highs. For exposure to zinc, we’re holding Nevsun Resources, and to zinc and coal, we hold Teck Resources.
At this time, we have limited exposure to the forestry sector. The Softwood Lumber Agreement between Canada and the U.S. expired a year ago, and on October 12, a one-year standstill will expire. At that time, it is likely that the U.S. will start trade action against Canada, imposing quotas and tariffs on Canadian producers until such time as a new agreement is reached. Until there is more clarity on a new deal, we are likely to steer clear of the sector, as in the past when these deals expired negotiations, arbitration and court rulings have taken years to settle.