Energy Class Commentary
Portfolio Sub-Advisor: Aston Hill Investments Inc.
Fund Commentary - March, 2011
For the first quarter of 2012 investors continued to enjoy the
market recovery that began in October of last year. The commodity
heavy TSX managed a 3.6% increase while the S&P 500 Index made
an impressive 12% gain. The underperformance of the Canadian
markets versus the US has accelerated as this recovery progressed.
The Canadian resource economy is heavily dependent upon moderating
Chinese growth prospects, but a leadership transition in China will
ensure focus on a soft landing. When considering the absolute size
of the Chinese economy (#2 worldwide), a growth rate of 7-8% is
still a big number. The US recovery, continued to gain traction in
Q1 as the unemployment rate dropped to 8.3% from the highs of 10%
which, although is a considerable improvement, is a level that
still concerns the Fed but to the disappointment of the markets,
this was not enough to hint at any new stimulus measures.
Macroeconomic risks related to the Euro-area appear to be
subsiding, and, after several years of tormenting the markets, have
lost headline focus to the sustainability of global growth.
Consequently, much of the first quarter advance was a payback from
investors mispricing an economic recession (i.e. a multiple
expansion). However, the P/E's on both the TSX and S&P are
still only around 14.5 versus their historical average of 19.
Growth expectations going forward may not warrant a repricing to
historical levels quite yet but there is still plenty of room for
upside particularly for the lagging Energy sector.
While the broader markets improved in Q1, the TSX Capped Energy
Index dropped almost 2% partly due to freefalling gas prices but
also due to the relatively weak pricing of bottlenecked and
increasingly abundant Canadian crude compared to international
Brent prices and even similarly disadvantaged WTI. Brent was up
another 15% in Q1 while Canadian crude prices dropped about
7%. Fortunately, this wider than normal spread is expected to
be short-lived as current refinery turnarounds are expected to be
completed by June, which is also when the Seaway pipeline reversal
begins, bringing landlocked crude to the Gulf Coast. There is
also concern that high energy prices will suppress the macro
recovery; however, low natural gas and electricity prices offset
some of the oil burden keeping total energy costs for US consumers
at a manageable 5.5% of disposable income. With the IEA's global
oil demand forecast up ~800,000 bpd over last year and non-OPEC
supply growth reduced to 730,000 bpd from 900,000 bpd, OPEC
effective spare capacity stands at only 3% of total global demand.
This coupled with ongoing geopolitical risks and a global GDP
growth forecast of 3.3% suggest that high oil prices are likely to
persist and perhaps move up further.
Unlike oil, natural gas appears doomed to languish for an
extended stretch. After the fourth warmest winter on record and
some U.S. natural gas storage sites turning customers away this
past week, the price of natural gas dropped to the lowest level in
a decade. Thankfully, some relief may be on the horizon: Chesapeake
believes 90-95% of drilling to hold leases is complete and the
natural gas rig count has dropped from 809 to 658 over the first
quarter. Associated gas from oil and liquids activity will
perpetuate the oversupply condition in North America, but with some
help from a potentially hot summer and significant incentive to
divert drilling away from dry gas after hold by production activity
is fulfilled, North American gas prices should begin crawling
back.
Rock bottom gas prices have forced many juniors to reassess
their business strategy, resulting in an outright sale or merger in
some cases which prompted the sale of Fairborne, Anderson and
Bellamont in the Portfolio. Provident Energy was also sold
after announcing a takeover by Pembina Pipelines who did not meet
valuation standards for the Portfolio; however, this combination
was not out of necessity but rather a cost of capital arbitrage.
The Portfolio Sub-Advisor took the opportunity to high-grade the
Portfolio and added oil weighted, catalyst rich names like Devon
Energy, Parex Resources and Midway Energy (who has since been
takenover by Whitecap at a 13% premium). NAL Energy was also added
for it's 8% yield and attractive valuation but has since announced
a merger with Pengrowth thus adding a 9.5% yield instead. The
weighting to the Services sector decreased about 3% in Q1 with the
sale of Patterson-UTI and now sits at 27.5%. The TSX Energy
Equipment and Services Index was flat over the first quarter
despite record earnings for the Services sector which prompted
several dividend increases from the group. Lack of confidence in
earnings estimates stemming from slowing natural gas activity is
misplaced since increasing oil activity favours service companies
as oil wells are often 10 times more service intensive than gas
wells. The sector remains undervalued both historically and on a
forward P/E basis and the Portfolio Sub-Advisor intends to maintain
the current weighting. With an overweight position in oil at 43%
versus 28% natural gas, the Portfolio stands to benefit from a
Canadian crude price recovery, and a repricing of energy assets in
general as global growth chops along unencumbered by justifiably
high oil prices. The Portfolio manager will opportunistically seek
to invest according to strict valuation standards within the
context of European austerity, geopolitical issues affecting crude
oil, and Chinese growth moderation.