Canada Moves to Diversify Energy Export Markets

By David Dittman • November 8, 2013 • In Brief

Editor’s Note: What follows is the executive summary of the November 2013 issue of Canadian Edge. Thanks for reading.

That the US Commerce Dept reported this week that gross domestic product (GDP) for the world’s largest economy expanded by an initial measure of 2.8 percent is indisputably good news for Canada.

So is the initial report that the US economy created 204,000 jobs in October–the first half of which was marred by the shutdown of the federal government.

The US and Canada exchange approximately USD1.3 million in goods and services every minute, nearly USD2 billion every day. In 2012 the US and Canada, which together form the world’s largest bilateral trade relationship, exchanged USD742.5 billion in goods and services.

Of the 50 US states, 35 count Canada as their No. 1 export market, with Canada ranking in the top three export markets for another 12 states. The US, meanwhile, absorbs approximately 70 percent of Canada’s total exports.

In 2012 Canada exported 1.08 billion barrels of oil and oil products across the 49th parallel, according to the US Energy Information Administration.

It’s an important relationship for both parties, and what’s good for the senior partner, the US, is good for the junior partner, Canada.

The future of Canada’s economy will certainly include a robust and critical relationship with its southern neighbor. But the long-term picture necessarily includes Asia, which includes the fastest-growing economies in the world.

Those emerging markets are energy-hungry, and Canada has that in abundance.

Canada is set to effectively compete for Asian energy customers with a host of other exporting countries in the next decade, the country’s energy minister said Tuesday.

Canada is the main source of energy imports for the US, but circumstances are changing.

This week Alberta Premier Alison Redford and British Columbia Premier Christy Clark announced a framework agreement between the two provinces that will facilitate the movement of energy resources to new markets.

This announcement is widely viewed as a keystone in the foundation for pipelines to be built that would carry Alberta’s oil to British Columbia’s coast, where it can be shipped to Asia.

It’s a major signal that Canada will soon diversify its oil exports away from the US, allowing its producers to get a world price for its products and relegating discussion of “price differentials” to the dustbin of history.

Canada’s oil exporters are currently in the position of having to accept cut-rate prices at the US border because of a lack of infrastructure, including pipelines, to move product to other end-markets. Rapid expansion of US production capacity has also created a glut that isn’t helping things.

There are other ways Canada can engage with Asia, specifically liquefied natural gas (LNG). Development of LNG export capacity will put Canada in direct competition with the US, where several projects have recently been approved for export to countries with which the US doesn’t have a free-trade agreement.

Canadian Minister of Natural Resources Joe Oliver indicated recently that numbers run on potential LNG export projects from British Colombia make them competitive with the US as well as other market participants such as Australia, Russia, East African nations and Qatar, currently the world’s No. 1 exporter and it lowest-cost producer.

Surging gas production in Canada and the US has widened the price differential between gas at home and prices Asian buyers of LNG are accustomed to paying. Prices in Asia are as much as four or five times as prices in North America.

Canada has an estimated 200 years of gas supply, more than enough to serve its relatively small population and also benefit from demand in Japan, Korea, China and India. Its stable institutions and traditional respect for the rule of law make it an attractive destination for foreign investment capital, for the oil sands as well as LNG export development.

According to the Asian Development Bank, gas use in Asia and Oceania will increase by an average of 3.9 percent per year over the next couple of decades, more than doubling to 1.4 million tons of oil equivalent in 2035 from 567 million in 2010.

The US is on relatively even footing with Canada when it comes to gas liquefaction facilities and LNG export terminals, but its infrastructure for oil and gas transportation is better. Australia has a head start on both, with several projects already under construction, though rising costs have led some operators to recalibrate their plans.

Environmental regulations remain a critical impediment to project development, as does the absence of infrastructure. As we noted in last month’s In Focus feature, the Canadian federal government is doing what it can to ease the process of obtaining project licensing.

Mr. Oliver said in remarks to the World Economic Forum in Seoul, South Korea, in October that over the next decade Canada will require CAD650 billion of investment to develop its resources. His next stop was China, where he continued to promote investment in Canada’s energy sector.

The most obvious manifestation of Canada’s infrastructure deficit is a persistent spread between Western Canada Select and West Texas Intermediate that has fluctuated in recent years but is currently around USD40 per barrel. Canadian gas is also cheaper compared to US gas.

Should the Alberta-British Columbia lead to pipeline construction these spreads will close. And that will help the Canadian economy, growth of which has been constrained somewhat due to lower realized energy prices. It could also stimulate foreign direct investment in oil sands development.

These are strong positives for the Canadian dollar.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

Third-quarter earnings reporting season has been generally solid for Canadian Edge Portfolio Holdings, in some cases borderline spectacular, in others maybe just a bit underwhelming.

The good news is that, thus far, we’re pleased with the lineup and have no significant changes, save an extraordinary buy-under target increase for Holding that hasn’t announced a dividend increase.

Reports for the following companies are discussed this month:

Conservative Holdings

AltaGas Ltd (TSX: ALA, OTC: ATGFF)
Brookfield Renewable Energy Partners LP (TSX: BEP-U, NYSE: BEP)
Cineplex Inc (TSX: CGX, OTC: CPXGF)
Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)
Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)
Dundee REIT (TSX: D-U, OTC: DRETF)
Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)
Keyera Corp (TSX: KEY, OTC: KEYUF)
Northern Property REIT (TSX: NPR-U, OTC: NPRUF)
Pembina Pipeline Corp (TSX: PPL, NYSE: PBA)
Shaw Communications Inc (TSX: SJR/B, NYSE: SJR)
TransForce Inc (TSX: TFI, OTC: TFIFF)

Aggressive Holdings

ARC Resources Ltd (TSX: ARX, OTC: AETUF)
Extendicare Inc (TSX: EXE, OTC: EXETF)
Newalta Corp (TSX: NAL, OTC: NWLTF)
Wajax Corp (TSX: WJX, OTC: WJXFF)

Note that results for Brookfield Real Estate Services Inc (TSX: BRE, OTC: BREUF) and Acadian Timber Corp (TSX: ADN, OTC: ACAZF) are discussed in this month’s Best Buys feature.

And note that we’ll have a Flash Alert concerning Atlantic Power Corp (TSX: ATP, NYSE: AT), which reported on Thursday evening, Nov. 7, after the market close and hosted a conference call on Friday morning, Nov. 8, on Monday, Nov. 11.

Portfolio Update has details on financial and operating results for 16 Portfolio Holdings that had reported in time for review in this issue.

Best Buys

Brookfield Real Estate Services Inc’s (TSX: BRE, OTC: BREUF) business model is built around fixed fees and augmented by transaction income derived from its Canada-focused real estate service and ensures more stable revenue. The latter’s softwood and hardwood lumber, pulp products and biomass byproducts tie it to construction activity in North America and Europe, with much greater exposure to economic ups and downs.

Both companies are enjoying a North American and global economic rebound that continues to gather strength, as reflected in third-quarter financial and operating numbers as well as by management commentary and outlook about the future.

Brookfield Real Estate has increased the company’s targeted annual cash dividend per share from CAD1.10 per year to CAD1.20 for 2014, reflecting management’s confidence that a widely feared correction for the Canadian housing market, though it did happen, has passed and was nowhere near as severe as some observers expected.

Brookfield Real Estate Services is a buy under USD14.

In its presentation of third-quarter numbers management of Acadian Timber Corp (TSX: ADN, OTC: ACAZF) noted that the US housing market “has entered a period of stabilization,” with improvement to be driven by new homeowners rather than investors.

Housing starts and average home prices in the US continue to improve on a year-over-year basis, though the rate of increase and consensus expectations have moderated since the second quarter.

Affordability is a key metric, and the Fed’s decision to delay the “tapering” of its bond-buying program will help keep interest rates–and therefore mortgage rates–relatively low.

Management expressed confidence in the recovery of the US housing market, based on feedback and orders from Acadian’s solid wood customers, most of whom are boosting capital investment, increasing operating shifts and ramping up log purchases.

Acadian Timber Corp is a buy under USD13.

Best Buys has more on the Portfolio Holdings that represent our top ideas for new money in November.

In Focus

As of this writing three of Canada’s six largest banks are near 52-week highs established during early trading on the Toronto Stock Exchange (TSX) on Friday morning, Nov. 8, 2013.

The other three reached their one-year home-market price peaks on Oct. 29 and Nov. 1, two topping out on the latter date.

It’s heady times for a group of institutions that together have helped earn Canada the title as the world’s most sound banking system from the World Economic Forum for six years running.

The aggregate dividend record is impressive as well, with the Big Six combining for 27 payout increases since November 2010.

That’s despite regulatory and fundamental challenges, including an effort by the Canadian federal government to cool Canada’s housing market via new mortgage restrictions, new rules on capital buffers recently imposed to protect against the potential impact of another financial crisis and generally weak economic conditions in North America.

In Focus profiles Canada’s Big Six banks, including our top choice, Bank of Nova Scotia (TSX: BNS, NYSE: BNS) and two new buys, Bank of Montreal (TSX: BMO, NYSE: BMO) and National Bank of Canada (TSX: NA, OTC: NTIOF).

Dividend Watch List

Encana Corp (TSX: ECA, NYSE: ECA) has followed through with a 65 percent dividend cut after new management signaled a dramatically new approach was required to get Canada’s largest natural gas producer out of its stock-market funk.

The new strategy involves significant job cuts, an asset spinout and a more focused 2014 development program. Encana’s moves have been well received thus far, and it’s graduating from the Dividend Watch List, though with dubious honors due to the dramatic dividend cut.

Cathedral Energy Services Ltd (TSX: CET, OTC: CETEF) has earned its way off the List with solid third-quarter numbers, including a 10 percent dividend increase.

Exchange Income Corp (TSX: EIF, OTC: EIFZF), though management has expressed its commitment to the current dividend rate, merits inclusion on the List due to an announcement that third-quarter earnings before interest, taxation, depreciation and amortization (EBITDA) will be approximately half of year-ago totals due to margin pressure at its WesTower unit.

Dividend Watch List has the details on members of the How They Rate coverage universe whose current dividend rates are in jeopardy.

Canadian Currents

Although economists believe Canada is at least a couple quarters away from the level of growth necessary to sustain its economy, there have been some positive numbers recently that should help pacify investors.

Nevertheless, there are concrete signs of an economic rebound in the Great White North, explains CE Associate Editor Ari Charney in this month’s Canadian Currents.

Canadian Currents details reasons for optimism about the US, the Canadian and the North American economy.

Bay Street Beat–We’re a little more than halfway through reporting for the CE Portfolio. Here’s what Bay Street analysts have had to say about those holdings that have reported financial and operating numbers.

How They Rate Update

Coverage Changes

CML Healthcare Inc (TSX: CLC, OTC: CMHIF) shareholders approved the CAD10.75 per share buyout of the company by LifeLabs Ontario, and the Ontario Superior Court of Justice has issued a final order approving the plan of arrangement.

Will all necessary approvals in, the transaction has closed. Shareholders should by now have received CAD10.75 per share in cash. CML has de-listed from the Toronto Stock Exchange.

CML has now been removed from How They Rate.

We’re in the process of evaluating members of the coverage universe based on a combination of low market capitalization, low daily trading volume on the Toronto Stock Exchange and in the US and, most importantly, for those that aren’t paying a dividend at present, whether there’s a reasonable likelihood of ever doing so in the near future.

This is part of an effort to streamline our focus on companies with a realistic opportunity to build wealth for investors for the long term, keeping in mind too that part of the rationale for building a coverage universe is to provide context and comparison.

With all this in mind, barring any objections from readers, which you can express via our “Stock Talk” feature at www.CanadianEdge.com, we will begin paring the ranks next month.

We are discontinuing coverage of Tuckamore Capital Management Inc (TSX: TX, OTC: NWPIF), which hasn’t paid a dividend in more than five years, has a market cap of CAD21.5 million and trades on very light volume on the Toronto Stock Exchange (TSX) and only sporadically on the US over-the-counter (OTC) market.

We’re also removing Lanesborough REIT (TSX: LRT-U, OTC: LRTEF), which hasn’t paid a dividend since March 2009 and is valued at just CAD13.9 million, from How They Rate coverage. An average of just more than 5,000 shares a day has traded on the TSX over the past 15 days.

Tree Island Steel Ltd (TSX: TSL, OTC: TWIRF), which pays no dividend and has a market cap of CAD14.6 million, is also no long part of the coverage universe.

We’re still considering our coverage of Armtec Infrastructure Inc (TSX: ARF, OTC: AIIFF), which pays no dividend and has a market capitalization of CAD49.6 million, and Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF), which discontinued its dividend in March 2011 and has a market capitalization of CAD85.6 million.

Advice Changes

Bank of Montreal (TSX: BMO, NYSE: BMO)–From Hold to Buy < 66. BMO is enjoying the benefits of its recent US expansion, in terms of earnings as well as in the form of renewed respect from investors. Solid capital management sets it up to reward shareholders for the long term with share buybacks and dividend growth.

National Bank of Canada (TSX: NA, OTC: NTIOF)–From Hold to Buy < 85. The smallest of the Big Six has consistently outperformed its peers on a total return basis over the past decade, and its expanding Canadian footprint presents opportunity for solid growth. Management has been aggressive about raising the dividend in the aftermath of the Great Financial Crisis.

Cathedral Energy Services Ltd (TSX: CET, OTC: CETEF)–From Hold to Buy < 6. Cathedral raised its dividend by 10 percent, as management reported another strong quarter of results and provided solid commentary on order activity for its directional drilling and production testing services.

First Quantum Minerals Ltd (TSX: FM, OTC: FQVLF)–From Hold to Buy < 20. Strong third-quarter earnings…

Yellow Media Ltd (TSX: Y, OTC: YLWDF)–From SELL to Hold. The company reported a decline in overall revenue, but digital revenue for the third quarter grew by 10.5 percent to CAD101.6 million from CAD92 million a year ago, due to the execution of a new sales strategy, continued migration of print revenue towards digital products and services and the launch of new mobile and premium digital products in 2012.

Digital revenue represented approximately 42.8 percent of total revenue during the third quarter, up from 34.3 percent a year ago. Long-awaited progress in its transition from print seems to be arriving.

Rating Changes

Encana Corp (TSX: ECA, NYSE: ECA)–From 3 to 2. As part of a significant strategic shift management announced on Nov. 4 a 65 percent reduction in the quarterly dividend rate to CAD0.07 from CAD0.20 per share effective with the fourth-quarter payment due Dec. 31, 2013, to shareholders of record as of Dec. 13.

That’s enough to lose a point on the Safety Rating System criterion of “no dividend cuts over the past five years.”

The core of my selection process is the six-point CE Safety Rating System, which awards one point for each of the following. A rating of “6” is the safest:

Payout Ratio–A ratio below our proprietary industry baseline.
Earnings Visibility–Earnings are predictable enough to forecast a payout ratio below our proprietary industry baseline.
Debt-to-Assets Ratio–A ratio below our proprietary industry baseline.
Short-Term Debt Ratio–Debt due in next two years is less than 10 percent of market capitalization.
Business Stability–Companies that can sustain revenues during recessions are favored over more cyclical ones.
Dividend History–No dividend cuts over the preceding five years.

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