March 2012
by Joanne Hruska
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 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, 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 nat 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, Seaview, and Kallisto in the portfolio. This provided the opportunity to highgrade the portfolio and undervalued, catalyst rich names like Parex Resources, RMP Energy and Crew Energy were added. Undervalued NAL Energy was also added for its attractive 8% yield but has since announced a merger with Pengrowth thus adding a 9.5% yield instead. 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 nat 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. The weighting to services dropped from 19% to 16% after the sale of Enseco Energy Services which had been struggling under high debt loads.
The fund lost 3.3% over the first quarter due mostly to the underperformance of the Canadian energy markets and partly due to the 50% allocation to downtrodden small caps. With an overweight position in oil at 44% versus 34% 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.
