Canadian Oil and Gas Equity Pressure Indicates Increased Short-Term Risk

by: Zvi Bar

Canada is the largest foreign supplier of energy to the United States and shares a large and friendly border that facilitates easy distribution and further pipeline development. If commodity supply shortages and growing global demand for most things assist other inflationary pressures in increasing natural resource prices, this Canadian industry may act as a currency and inflation hedge in a greater portfolio.

Many Canadian oil & gas entities were organized as Canadian Royalty Trusts (CanRoys), designed similarly to U.S. MLPs in that they avoided taxes. Canada eliminated these trusts, and most of them have since converted into corporations. Nonetheless, some of these companies continue to pay out high yields, assisted by some carry forward tax write-offs.

Like MLPs, many of the higher yield providing Canadian oil & gas companies may not only act as an energy commodity investment, but also to supplement the high yield portion of an income portfolio. Many offer monthly dividends and competitive yields.

I previously identified seven Canadian oil & gas companies with market capitalizations between $2 and $26 billion.

  1. Baytex Energy Corp. (NYSE:BTE): Yield: 4.2%
  2. Cenovus Energy Inc. (NYSE:CVE): Yield: 2.4%
  3. Enbridge Inc. (NYSE:ENB): Yield: 3.2%
  4. Enerplus Corporation (NYSE:ERF): Yield: 7.2%
  5. Pengrowth Energy Corporation (NYSE:PGH): Yield: 6.4%
  6. Provident Energy Ltd. (PVX): Yield: 6%
  7. Penn West Petroleum Ltd. (PWE): Yield: 4.4%

The market appears to value these companies almost exclusively upon the price of oil and interest rates. As such, they have performed well over the last two years as oil rebounded in value - (click charts to expand):

Can 2YThese Canadian companies also moved with oil over the last year, first in 2010 on the strength of the general move in commodity prices, and again at the start of 2011, due to Middle East instability:

Can 1Y

Recently, though, oil prices spiked downward based upon easing supply concerns and some Wall Street predictions. These companies have stalled and appear to be waiting out the next move in oil, coupled with possible fear over wildfires in Alberta:

Can 1M

This chart also indicates that the largest recent (1 month) reduction in market values was in BTE (near 10%), which also had the highest prior appreciation (as shown in the earlier charts). Since the start of 2011, these companies have largely entered a trading range. The chart, below, shows that BTE’s recent under-performance countered its prior out-performance and placed it within the broader group’s 0-20% range, where the year-to-date performance of the group is wholly positive.

Can YTD This recent downward move may continue. Oil normally appreciates for the summer due to demand, but has thus far moved in the other direction. This counter-intuitive move and the general belief that oil is at or near a price where any increase will negatively affect gasoline demand and use may halt the general move upward in these Canadian oil & gas companies, and possibly reverse it.

These companies, like so many others, are also likely waiting out U.S. interest rate policies and potential economic impacts. Many investors to these Canadian oil & gas names, especially the higher yielding ones, allocated here for their monthly income and several may opt out if the ‘risk free’ rate of interest begins to increase from its now historically low levels.

This, though, discounts the potential for oil price increases to continue to outpace interest rates due to the inflation and general global demand. It also discounts the potential future strength of the Canadian dollar versus the U.S. dollar. Moreover, natural gas prices have largely stayed depressed over the past few years, and it appears that these companies have unappreciated exposure to possible increases to natural gas prices.

Given the recent negative performance by this group and the larger general nervousness within the equities and bond markets, it appears that these natural resource linked Canadian equities now possess a higher level of risk than they are normally accustomed to. A further, short-term correction of 10-20% appears possible and should be considered a risk. Nonetheless, the fundamental businesses appear sound and their conversions from Canroys appear well handled and received by the markets.

Disclosure: I am long PGH.

Disclaimer: Investments should be considered on their own merit and relative to the total portfolio of investments.