Sink or Swim?

Three things to look for when de­cid­ing which en­ergy com­pa­nies are worth your dol­lar

Alberta Oil - - SMART MONEY - Martin Pel­letier is a port­fo­lio man­ager at TriVest Wealth Coun­sel, a Cal­gary-based in­vest­ment man­age­ment firm with spe­cialty of­fer­ings in­clud­ing an oil & gas hedge fund

WE ARE NOW ONE AND A HALF YEARS

into what is no doubt a full-fledged com­mod­ity cri­sis and it is look­ing likely that this will be one of those dreaded low­er­for-longer pe­ri­ods. The global com­mod­ity com­plex was vastly over cap­i­tal­ized re­sult­ing in a mas­sive sup­ply glut that will take some time yet to work through, while global de­mand growth is slow­ing.

This is not good news for oil and gas com­pa­nies, which tend to be re­ac­tive rather than proac­tive and are only just now start­ing to take the nec­es­sary steps to en­sure they are able to sur­vive any pro­longed pe­riod of low oil and gas prices.

It is akin to the re­al­ity TV show Sur­vivor whereby con­tes­tants do ev­ery­thing in their power to make it to the next round. The prob­lem is that it may be al­ready too late for many of the oil and gas cast­aways that are on the verge of get­ting voted off of the is­land.

In­vestors, there­fore, have to ex­er­cise ex­treme prej­u­dice when in­vest­ing in the sec­tor. To help, there are three key fac­tors in­vestors need to look at when de­cid­ing which com­pa­nies will be able to sur­vive un­til prices even­tu­ally re­cover.

Beware of the yield trap

In­vestors can get sucked in by high div­i­dend yields, oth­er­wise known as the yield trap. One can’t blame them as th­ese dou­ble-digit yields can be very en­tic­ing es­pe­cially in this ul­tra-low in­ter­est rate en­vi­ron­ment. But a high yield is of­ten a warn­ing sign that some­thing isn’t right. For ex­am­ple, at the start of the year the TSX-listed oil and gas com­pa­nies with the largest div­i­dends had an av­er­age div­i­dend yield of 11.4 per cent. In­vestors in th­ese com­pa­nies saw their share prices col­lapse an av­er­age of 42 per cent since then com­pared to the S&P TSX Capped En­ergy In­dex, which was down only 17 per cent over the same pe­riod.

Debt works both ways

Com­pa­nies with high debt loads can be en­tic­ing dur­ing pe­ri­ods of strong oil or nat­u­ral gas prices, be­cause they are es­sen­tially lever­ag­ing their ex­po­sure to the com­mod­ity. Dur­ing the good times those com­pa­nies will gen­er­ally have a debt-to­cash-flow mul­ti­ple of two times or more, which doesn’t look too bad – at least un­til com­mod­ity prices start to cor­rect.

While on the sur­face their to­tal en­ter­prise value re­mains some­what flat, debt quickly takes over the mar­ket cap­i­tal­iza­tion, leav­ing lit­tle in the end for share­hold­ers. We cal­cu­late that those com­pa­nies with a higher debt load have seen their share price fall by a whop­ping 60 per cent this year, with more down­side ahead.

High cost pro­duc­ers pose the great­est risk

Com­pa­nies with high and in­ef­fi­cient cost struc­tures will not be able to weather the storm. And it wouldn’t be un­usual to see some of th­ese com­pa­nies soon turn cash­flow neg­a­tive should oil and nat­u­ral gas prices fall fur­ther.

Un­for­tu­nately, many of th­ese poorly run com­pa­nies do not un­der­take any sort of mean­ing­ful hedg­ing or risk man­age­ment pro­grams that are now prov­ing to be life­lines for those that were pru­dent enough to un­der­take them. It’s also wise for those in­vest­ing in the sec­tor to run their own sim­u­la­tion, and stress test a com­pany to see how long it can last un­der its cur­rent cost struc­ture, and then es­ti­mate un­der which sce­nario it starts to get into se­ri­ous trou­ble. One needs to do a bit of home­work first to find the cor­po­rate de­cline rate, the pre­vi­ous cap­i­tal ef­fi­cien­cies, and the over­all cost struc­ture and net backs. While there is likely more pain on the im­me­di­ate hori­zon, we still be­lieve the cur­rent en­vi­ron­ment of­fers some ex­cel­lent value op­por­tu­ni­ties.

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