HOW TO RESCUE YOUR PORTFOLIO FROM AN OIL-INDUCED SLUMP
It’s been a terrible year for energy investors with oil prices down nearly 14.7 per cent in 2017 and the S&P TSX Capped Energy Index down nearly 21.7 per cent. To make matters worse, this may actually be understated as Suncor Energy and Canadian Natural Resources, which are down only 12.5 per cent and 11.8 per cent, respectively, account for 45 per cent of the index.
This compares to companies such as Cenovus Energy and Crescent Point Energy, which are down a whopping 53.6 per cent and 48.8 per cent to levels not seen since oil was at $26 a barrel back in early 2016.
The problem is that the broader equity market has disconnected from oil and other commodities with the argument that technological efficiencies are resulting in higher economic growth without higher energy consumption.
While this may play a role, we think it is more the case that financially engineered growth incentivized by record low interest rates has resulted in asset inflation in most sectors excluding energy, where it has had the opposite effect. This is because low rates have made debt readily available to energy companies that have reacted by bringing on more oil in an already oversupplied market.
Consequently, you now have the situation where oil companies have become over-leveraged in a range-bound but volatile oilprice environment. This means that many oil companies are effectively transforming themselves into levered oil ETFs that move a magnitude higher and lower with oil prices.
Here in Canada, debt-heavy producers have been affected by more than just falling oil prices.
The Bank of Canada’s recent decision to raise interest rates has resulted in higher debt servicing costs, while breaking the loonie’s historical relationship to oil prices.
Unless a company has borrowed in U.S. dollars, the net impact of a higher loonie is quite negative as cost structures are in Canadian dollars while revenue streams are in U.S. dollars. To add insult to injury, they also have to deal with a new carbon tax while transport costs remain high given the continued pushback against building out a national pipeline to either coast.
All of this leaves investors with energy-heavy portfolios, not an unusual situation here in Alberta, wondering what they should do. The good news is that there are plenty of options but all require a bit of work — something your adviser should be doing for you.
The first is to identify the size and type of debt each company holds along with the debt maturity schedule. For example, any large amount of debt maturing in the next few months could prove quite troubling for the company unless oil prices rebound so look for those with a couple of years on their debt schedule.
The next step is determine if they have the ability to service that debt from existing cash flow generated in the current oil price environment when factoring in the required capital to keep production somewhat flat. One can utilize previous capital efficiency ratios against production decline rates to determine maintenance capital and then calculate expected cash flow under the current oil price (factoring in forward hedges of course).
Stay away from those having to sell assets in order to pay down debt to survive, as there is always a risk that the sale may not materialize or worse, that they may have to sell their best assets.
After such due diligence you may discover that there are some debt-heavy companies that will have quite a bit of time before trouble sets in and they will move the most with a recovery in oil prices. The key is to ensure your energy portfolio hold these companies instead of the ones that won’t survive a prolonged low oil price.
Finally, with the rally in the Canadian dollar one may want to look south of the border and swap out into some U.S. oil companies.
Many are not only better capitalized but operate in a much more supportive environment.