Market Q and A: Canada, Energy and Asia

China announced a USD586 billion stimulus package Nov. 9, an amount equal to nearly a fifth of the country’s GDP. Global markets reacted with initial glee before turning negative in the face of discomforting economic news.

But the prospect of serious pump priming in the global economy’s growth leader had longer lasting impact on the Toronto Stock Exchange: The commodity-intensive board held onto gains Monday even as the major US indexes wilted under disappointing earnings announcements.

China’s effort is certainly no panacea for Canada or the world economy. There are many hurdles to surmount. But the announcement and the corresponding impact on publicly-traded Canadian companies tied to commodities illustrates several important points. One, Canada is intricately tied, and it’s a positive link, to a global economy the growth, which is now led by emerging Asia. Two, emerging Asia’s growth means demand for Canada’s resources will only increase–once we cycle out of this malaise. And three, Canada has used its resource wealth to establish a solid financial system.

What follows is the Canadian Currents article from the November 2008 issue of Canadian Edge. At a time when questions about the direction of the global economy dominate not only the financial media but regular news as well, I thought it would be useful to speak with our in-house energy and Asia experts, Elliott Gue of The Energy Strategist and Yiannis Mostrous of The Silk Road Investor, respectively. Providing a Canadian context for our conversation is, of course, CE’s Roger Conrad.

Question: What would a deep global recession mean to Canada?

Roger Conrad: The best way to think generally about Canada’s economy is in two parts. The eastern part is more industrial and has traditionally depended heavily on exports to the US. It includes Atlantic Canada, French-speaking Quebec and Ontario and is where most of the population lives.

The western part of the country is heavily dependent on the development and export of natural resources. Most resource exports still go to the US, including the fast-growing oil sands. But over the past few years an increasing amount of them have gone to developing Asia.

It’s this new relationship that’s really helped Canada buck the worst of the troubles in this country. But a deep global recession that really knocked down growth in China would have a very serious impact on growth.

Elliott Gue: A deep global recession would be a big negative for crude oil and, to some extent, natural gas prices. As Roger noted, Canada’s economy has a significant dependence on energy and commodity prices so the economy would clearly be hit by falling prices.

Question: So, Elliott, where are we now in the cycle? And what do the long-term fundamentals say about the direction of energy prices?

Elliott Gue: We’re not really seeing a truly global recession at this time, and I suspect the current weakness in energy commodities will be short-lived. On the demand side, there’s clearly been a retrenchment in developed-world oil demand. The latest Oil Market Report for the International Energy Agency (IEA) projects that oil demand from the developed world will fall by nearly 1.1 million barrels a day in 2008 and a further 600,000 barrels a day next year. The decline has been led by a slowdown in the US; US oil demand is likely to decline close to 1 million barrels a day in 2008.

Meanwhile, demand from the developing world has slowed slightly but is still growing at an impressive pace. In fact, demand is growing so quickly it’s offsetting the declines from the developed world–global oil consumption is expected to be up around 450,000 barrels a day in 2008 and closer to 650,000 barrels a day next year. There does not appear to be a recession in the developing world at least in terms of oil consumption.

And investors are paying far too little attention to the supply side. Recent data out of the IEA suggest that production from mature oilfields is declining at a far faster pace than previously thought–oil production from key mature fields in regions like the North Sea, Mexico and even Russia is falling quickly. Even in the favorable economic environment of the past four years, producers in these regions have had a difficult time maintaining their production

To make matters worse, smaller firms in high cost markets like the North Sea start cutting back their drilling plans when oil falls below USD80. Falling activity levels will quickly show up in supply statistics.

Bottom line: the longer oil prices remain depressed, the more profound the effect on global oil supply. If, as I suspect, the US economy and oil demand stabilize towards the latter half of 2009, there just won’t be sufficient supply to meet that demand. We’re likely to see crude back over USD100 by late 2009 or early 2010.

Question: Roger, how deep is Canada’s relationship with Asia and where do you see it going?

Roger Conrad: The more China and other Asian nations develop their economies–and governments are clearly committed to doing that–the more resources they’re going to need. Canada is the natural seller of those resources, and I see exports continuing to grow for at least the next 10 years. One of the most telling numbers I’ve seen on this relationship is the percentage of Canadian exports that go to the US. Back in the late 1990s, this figure was in the high 90 percent range pretty much every year. Ten years later, it’s in the low 70s and still falling. That’s how commodity prices were able to keep rising through the first half of 2008, even with the US economy going into the tank.

Again, the great untold story on how badly Canada gets hit in this downturn is what happens to Asia. I defer to Yiannis on this. But my view is if China can bottom at 8 percent growth next year, they’re still going to need a lot of resource exports, and that should keep Canada on the whole from feeling this worst of this crisis.

Yiannis Mostrous: I agree. A lot of investors and commentators forget that the important development in the Chinese economy remains that of its domestic economic strength.

As for the global economy slowdown, I expect that the Chinese government will step up its investment plans in order to boost domestic economic activity.

Chinese authorities have traditionally stepped in to support the economy during difficult times through fixed-asset investment (FAI) increases. Their target has been to keep overall FAI growth at around 25 percent for the past eight years; before 2000, the goal was 15 percent.

Importantly, the rest of the region will also come out relatively fine from the crisis because it has a high savings rate and lower degree of financial leverage on both the personal and corporate level.

And Asian countries have current account surpluses–India and South Korea are the exceptions–as well as strong foreign exchange reserves. They have enough room to cut rates now as needed because they had raised rates earlier in the year due to higher inflation.

Elliott Gue: In addition to direct trade links, clearly Asia has a profound effect on the market for Canada’s key export commodities. Strong growth in demand for oil, natural gas, and agricultural commodities has been a key driver of the rally in these markets over the past five years.

Whether Canada ships its oil to the US or China, Asian demand is clearly having an impact on prices.

Question: At what energy price does Canada’s energy patch become noncompetitive on global markets?

Roger Conrad: The oil sands region is certainly pretty close to being there with oil under USD70 a barrel. Operating costs for this process have actually risen along with output, in large part because turning oil sands to useable fuel is pretty much a mining and chemical processing operation and requires large amount of electricity costs.

I think we can actually expect costs to rise even more going forward, as the industry is forced to tackle environmental effects, so oil sands is probably going to need an oil price of USD90 or higher to be economic in the long haul.

That said, it is a rising percentage of Canada’s oil exports and North America has become dependent on it to some extent. If the price of oil stays at this level for more than a few months, a lot of these projects could be shut down. That would potentially take a lot of energy off the market, which would all else equal push prices back to a higher level of equilibrium. That’s oil sands.

The conventional oil and natural gas that’s the bulk of Canada’s output is actually pretty competitive at a lot lower energy prices. Dividends would have to come down if oil were to drop to USD30 a barrel or gas fell to USD3 or so per million British thermal units (MMBtu). But they’d still be in business.

Elliott Gue:  This varies wildly by producer. Based on comments made during recent quarterly conference calls by the big services companies, some North American oil projects are economic at USD55 oil. But there are also small producers who aren’t profitable unless oil is over USD100.

A good rule of thumb is to watch oil around USD70 to USD80. Under that range, you’ll see capital spending cuts by smaller, higher-cost producers in the US and Canada. Above that range, drilling activity should remain at least stable.

It’s also worth noting that the credit crunch has had a profound impact. Many independent producers rely on debt capital to fund their drilling plans. Reduced access to capital has prompted some to cut back their spending even if they’re profitable with oil at current prices.

In addition to oil, keep an eye on natural gas prices and supplies in North America as a whole. In 2006 and 2007, North American natural gas prices were at depressed levels, and drilling activity in Canada was hit hard, far harder than in the US. While activity appeared to pick up earlier this year as gas prices spiked higher, it never recovered to the levels last seen in 2005 and early 2006.

With the 12-month natural gas strip–the average of the next 12 months of futures prices–currently at around USD7 to USD7.50, many smaller gas producers in Canada and the US alike aren’t profitable. The break point for the big independent exploration and production companies is around USD7.50 to USD8–below this range, companies scale back their drilling plans. We are already seeing that as several producers have announced cuts to their spending plans. I suspect the US rig count will fall by 300 to 500 rigs by mid-2009 as producers idle rigs and cut back drilling plans. Canada will see continued weak activity levels if gas stays where it is today.

Longer term, North America has the potential to become the dominant gas producer worldwide, overtaking even Russia in terms of production. The reason is the vast so-called unconventional gas fields that are being exploited in the US and Canada alike. Recent advanced in drilling technology have made these fields economic and production is soaring.

Just a few years ago, most energy pundits felt falling Canadian production would force the US to import massive quantities of gas in the form of liquefied natural gas (LNG). Now, thanks to unconventional gas, there’s talk of building LNG export facilities to allow North American gas to be transported to gas-hungry markets in Europe and Asia.

Question: Roger, let’s talk about the Canadian banking system. Can it survive a global recession?

Roger Conrad: Obviously, financial institutions all over the world take a hit when growth slows. But as we’ve pointed out in Canadian Edge, Canada’s banks are a great deal more conservative than US banks have been.

There was never a subprime crisis because they never went hog wild on subprime loans. In fact, the only significant writeoffs have had to do with investments in the US, and in US mortgage-backed securities.

Another advantage Canadian banks have had in this crisis is the Canadian corporations they lend to are also very conservative. Put that with the Canadian government’s pretty steady support of the country’s banks and you have a very nice combination for keeping lending flowing in a difficult environment.

Question: The ability to withstand a significant downturn: Yiannis, how is Asia’s financial system set to survive?

Yiannis Mostrous: Banks, consumers and companies in Asia enjoy low debt levels. As a result there are no serious economic threats from the poor liquidity conditions and financial insolvency issues plaguing the Anglo-Saxon economic system.

Question: “Whither Asia” is a topic many mainstream media types have pounded on during the last six to eight weeks. What kind of growth can we reasonably expect there in 2009?

Yiannis Mostrous: Well, I do think the Chinese economy will perform better than a lot of people think next year. Everyone’s talking about a slowdown in exports, and that this will hit China hard.

It’s true that an export slowdown will be a negative–in the past three years, exports have contributed substantially to GDP growth, and the economy grew at around 10 percent. But if we look a little further back, we’ll see–at times–that net export growth was in the low single-digits (in 2004) or even negative (in 2003). But GDP growth managed to rebound to the 10 percent area.

If you’re willing to account for the abnormality of the current global financial situation, thereby subtracting a few more growth points, China should still be able to deliver very respectable 8 percent growth next year.

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Conservative Portfolio

AltaGas Income Trust (TSX: ALA.UN, OTC: ATGFF) reported a 38.9 percent increase in net income to CAD53.5 million (CAD0.75 per unit), up from CAD31.4 million (CAD0.54 per unit) a year ago. The earnings boost was based on energy infrastructure assets from the Taylor acquisition, stronger performance from the field gathering and processing business, higher prices received on hedged power and a CAD13.8 million income tax recovery. Distributable cash flow per share came in at 79 cents per share, for a payout ratio of 68.4 percent.

Chairman and CEO David Cornhill said AltaGas expects fourth quarter results to be similar to third quarter numbers. The majority of AltaGas’ revenues are backed by contractual arrangements that provide stable and predictable cash flow. Dominion Bond Rating Service revised its trend on AltaGas to positive from stable and confirmed its medium-term notes at BBB (low) and its stability rating at STA-3 (middle). AltaGas Income Trust is a buy up to USD25.

Canadian Apartment Properties REIT (TSX: CAR.UN, OTC: CDPYF) reported a 12.8 percent increase in funds from operations (FFO) in the third quarter, from CAD20.8 million (CAD0.35 per unit) to CAD23.5 million (CAD0.36 per unit). Distributable income increased 11.4 percent to CAD23.7 million (CAD0.36 per unit); the REIT had a payout ratio of 76.8 percent for the period. Occupancy increased to 98.3 percent, while average monthly rents rose 2.9 percent.

Balance sheet health was maintained, as the ratio of total debt to gross book value came down to 61.6 as at Sept. 30, 2008, from 65.3 percent a year ago. The weighted average interest rate of CAP REIT’s total mortgage portfolio was 5.33 percent, while the weighted average term to maturity was 5.2 years. The REIT has CAD127.6 million available under its acquisition and operating credit facilities, up from CAD64.9 million at the same time last year. Steady, stable Canadian Apartment Properties REIT is a buy up to USD20.

RioCan REIT (TSX: REI.UN, OTC: RIOCF) reported third quarter net income of CAD41.6 million (CAD0.19 per unit), up from CAD35.9 million (CAD0.17 per unit) a year ago. Funds from operations (FFO), a key measure of REIT performance, was CAD81.3 million (CAD0.37 per unit), up from CAD76 million (CAD0.36 per unit). Portfolio occupancy was stable at 97 percent, and rents grew 10.9 percent over last year. The REIT also renewed 93.9 percent of expiring leases, reported progress on several promising projects and completed the acquisition of 12 properties in central and eastern Canada at good prices. Stable RioCan REIT, with a diversified portfolio that positions it well to weather the economic downturn, is a buy up to USD22.

Yellow Pages Income Fund (TSX: YLO.UN, OTC: YLWPF) reported a 20 percent increase in net income to CAD146 million (CAD0.28 per unit), up from CAD122.1 million (CAD0.23 per unit) a year ago. Revenue climbed to CAD426.1 million from CAD416.5 million on strength in its traditional directories business and solid performance that reflects continuing integration of its vertical media initiatives. Distributable cash was up 5.2 percent to CAD192.4 million (CAD0.37 per unit). The payout ratio for the third quarter was 78 percent. Still successfully evolving from print to Internet, Yellow Pages Income Fund is a buy up to USD12.

Boralex Power Income Fund (TSX: BPT.UN, OTC: BLXJF) benefited from strong water flows in the third quarter, posting net income of CAD2.8 million (CAD0.05 per unit), up from CAD1.5 million (CAD0.03 per unit) a year ago. Revenue grew 18.7 percent and operating cash flow ticked up 3.1 percent. Hydroelectric production in the US rose 65.2 percent as waterflows were 11 percent above historical averages. Canadian power production increased 42.8 percent as waterflows surged 29 percent above normal.

The wood residue business was hurt by the shutdown during the quarter of two Quebec power plants. Management announced it still expects to restart the woodwaste plants by the end of November and run them through the peak winter months. And Boralex was able to secure hedges for future US dollar cash flow at very favorable rates during the recent Canadian dollar volatility. The wood residue situation remains a worry. But selling for just 65 percent of book value and yielding more than 18 percent, it sure looks priced in, and these results are encouraging. Boralex Power Income Fund is still a buy for the more aggressive up to USD5.

Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF) announced a 95 percent year-over-year increase in third quarter funds from operations to CAD78.6 million. Production averaged 21,782 barrels of oil equivalent per day (boe/d), up 5 percent over the second quarter of 2008 and 11 percent from year-earlier levels. The production increase stems from Daylight’s successful capital program as well as its acquisition of Athlone Energy. Management affirmed its ability to fund both capital expenditures and the payout with internal cash flow for at least the rest of the year.

And the trust managed to slash its bank debt by 27.3 percent from second quarter levels. Further, operating costs per barrel of oil equivalent were flat with year-earlier levels, and the trust announced an increase in its capital budget for the coming year. Its unit price beaten down to the point where it yields nearly 20 percent, Daylight Resources Trust is a buy for the aggressive up to USD11.

Enerplus Resources (TSX: ERF.UN, NYSE: ERF) rode higher oil and gas prices to third quarter net income of CAD465.8 million (CAD2.82 per unit), up from CAD93 million (CAD0.72 per unit) a year ago. Oil and gas sales increased by 77 percent to CAD654.6 million, and the fund’s cash and non-cash commodity derivative instrument gains increased by CAD217.1 million. Revenue jumped 147 percent to CAD754.9 million from CAD305.7 million in the third quarter of 2007. Production averaged 95,644 barrels of oil equivalent per day (boe/d), down 5 percent from 100,188 boe/d.

Enerplus realized CAD8.25 per thousand cubic feet of natural gas, up 48 percent, and CAD110.63 per barrel of crude, up 60 percent. Enerplus reduced its reduced its monthly distribution to CAD0.38 per unit from CAD0.47, effective with the November payment, to better position to deal with a declining commodity prices and a slowing global economy. Long-term-focused Enerplus Resources is a solid buy up to USD40.

GMP Capital Trust (TSX: GMP.UN, OTC: GMCPF) is cutting its monthly distribution to CAD0.05 from CAD0.1042 per unit, eliminating 37 positions and trimming senior-level salaries by 10 percent as it rides out the damage done to its underwriting and advisory businesses by the global financial meltdown. Third quarter revenue was down 43 percent year-over-year to CAD74.8 million, while net income came in at CAD6.9 million, an 82 percent decrease. Distributable cash for the period was CAD12.5 million (CAD0.19 per unit, down 72 percent from CAD45.3 million (CAD0.72 per unit) in the third quarter of 2007. The payout ratio for the period was 179 percent, up from 52 percent. GMP Capital Trust, at the center of the financial storm, is a speculative buy up to USD8.

Newalta Income Fund (TSX: NAL.UN, OTC: NALUF) reported net income for the third quarter of CAD18.7 million (CAD0.44 per unit), up from CAD11.7 million (CAD0.28 per unit) a year earlier. Revenue for the three months ended Sept. 30 was CAD158 million, up from CAD143 million. Newalta also announced plans to convert into a corporation; the company will pay a CAD0.20 per share quarterly dividend rather than its CAD0.185 per unit monthly distribution.

In addition, Newalta extended the maturity of its CAD425 million credit facility to Oct. 2010; CAD115 million of the line is untapped. A 64 percent cut isn’t a happy circumstance, but Newalta has set out an aggressive growth plan; the waste management business is consolidating, and Newalta will use the cash flow flexibility and renegotiated credit lines to make acquisitions. Its unit price depressed, Newalta Income Fund would still yield 9 percent with its new payout scheme; it’s a buy for aggressive investors up to USD13.

Paramount Energy Trust (TSX: PMT.UN, OTC: PMGYF) saw a 55 percent year-over-year increase in realized natural gas prices, which pushed third quarter net income to CAD180.8 million (CAD1.62 per unit) from CAD5.2 million (CAD0.05 per unit). Production averaged 183.7 million cubic feet per day (MMcf/d), down from 193.1 MMcf/d in the third quarter of 2007. Paramount reported a CAD168.9 million gain because of an increase in the fair value of its hedging contracts.

Funds from operations (FFO) rose 85 percent to CAD76.4 million. Paramount distributed CAD0.30 per unit during the period, for a payout ratio of 44 percent of FFO. The trust paid down bank debt by CAD24.1 million, and spent CAD18.1 million to drill 25 wells and CAD16.9 million to acquire potential high-impact natural gas properties in west central Alberta. Paying down debt, aggressively hedging and investing in the long-term viability of its operations, Paramount Energy Trust is a buy up to USD10. 

Peyto Energy Trust’s (TSX: PEY.UN, OTC: PEYUF) net income rose 63 percent to CAD64.8 million (CAD0.61 per unit) from CAD39.9 million (CAD0.37 per unit) a year ago. Revenues grew 21 percent to CAD110.5 million from CAD91 million. Fund from operations totaled CAD74.5 million (CAD0.70 per unit), up from CAD62.9 million (CAD0.60 per unit) a year ago. Peyto distributed CAD0.45 per unit; the payout ratio came down to 64 percent from 71 percent in the third quarter of 2007.

Production for the quarter ticked up 1 percent to 19,740 barrels of oil equivalent per day (boe/d). Peyto invested CAD62.3 million to add net production of 2,100 boe/d during the quarter. Combined costs and royalties amounted to 30 percent of Peyto’s unhedged price; a roughly 70 percent profit margin ensures the trust can tolerate volatile commodity prices. Peyto Energy Trust is a buy up to USD18.

Trinidad Drilling’s (TSX: TDG, OTC: TDGCF) revenue increased 18 percent to CAD191.7 million in the third quarter on acquisitions, internal construction programs, higher utilization rates and successful expansion into the US. Trinidad’s third quarter utilization rate of 63 percent in Canada dwarfed the industry average of 48 percent. The US rate of 85 percent reflects the company’s successful expansion south of the border. Cash flow from operations was up 11 percent to CAD51.5 million (CAD0.53 per share). Net income was up 35 percent year-over-year to CAD20.4 million (CAD0.21 per share).

Trinidad will redeploy five Canada-based rigs to higher day-rate and utilization contracts, three to the Chicontepec field in central eastern Mexico, one to the Bakken play in North Dakota and one to the Haynesville Shale in Louisiana. All five rigs are under contract to work at 100 percent utilization during the respective contract periods. Its sensitivity to price fluctuations limited because of its long-term contracts, Trinidad Drilling is a buy up to USD12.

Vermilion Energy Trust (TSX: VET.UN, OTC: VETMF) reported net income of CAD86.9 million (CAD1.22 per unit) in the third quarter, up from CAD48.6 million (CAD0.71 per unit) a year ago. Revenue was up 31 percent to CAD245.7 million. Vermilion produced 31,927 barrels of oil equivalent per day (boe/d), down slightly from 32,172 boe/d in the third quarter of 2007; the production decline is attributable to scheduled downtime at facilities in the Netherlands and Australia.

Vermilion generated FFO of CAD131.8 million (CAD1.73 per unit) in the third quarter of 2008; Vermilion distributed CAD0.57 per unit in the quarter, equivalent to 30 percent of FFO. Vermilion reduced net debt by approximately CAD63 million to CAD222 million, equivalent to approximately 0.4 times annualized third quarter 2008 FFO. Vermilion’s existing line of credit of CAD675 million will help it fund growth through acquisitions. Conservative Vermilion, with its low payout ratio, is in good position to deal with lower commodity prices and is a buy up to USD40.