Natural Gas: Watch Your Leverage

By Roger Conrad • October 5, 2012 • In Brief

Editor’s Note: In August we made several improvements to the structure of the CE issue. These changes are intended to make In Brief, the executive summary of each issue, more concise and each article category more relevant. We welcome your feedback regarding these changes or suggestions for any further improvements you’d like to see via our Ask the Editor page. Thank you. — RSC

Is the natural gas rally for real?

Since bottoming at less than USD2 per million British thermal units (MMBtu) in late April the clean fuel has surged north of USD3.50. That’s a level not hit since early December 2011.

This reversal of fortune is partly due to weather. The winter of 2011-12 was one of the mildest on record. But the summer of 2012 was not quite so temperate. And at least the early indications are the winter of 2012-13 will be much closer to normal, and a lot colder.

Natural gas is, however, also benefitting from an historic shift of North American power generation away from long-time mainstay coal. For the first time ever power utilities are using more gas than coal to produce electricity. Gas-fired generation is up 21 percent this year from last and now accounts for 36 percent of all US gas consumption.

On the other side of the ledger are the vast reserves of natural gas in the US and Canada buried in shale that are now accessible and economic, thanks to hydraulic fracturing. New drilling stalled this year in the wake of prices that fell to nearly USD1 per MMBtu in some parts of Canada.

Overall production, however, is still expected to rise 4 percent this year. Moreover, inventories of the fuel are still well above the five-year average. Should rising prices encourage more gas drilling supply will rise all the more, virtually guaranteeing a rapid retreat.

Then there’s coal, which has seen a sudden price decline as global demand has fallen.

Given the black mineral’s potential environmental costs, USD3.50 may not be enough to convince US utilities to switch back. But every cent higher from here makes that option more attractive.

Several Canadian Edge Portfolio Holdings offer substantial exposure to gas’ upside.

Shares of Aggressive Holding Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF), for example, have surged into the black for the year after being down nearly 40 percent this spring.

ARC Resources Ltd (TSX: ARX, OTC: AETUF) is also up after slipping nearly 25 percent to mid-April.

More than 90 percent of Peyto’s output and two-thirds of ARC’s is natural gas. That’s more than Pengrowth Energy Corp’s (TSX: PGF, NYSE: PGH), as that company focuses on ramping up oil output from the properties of the former NAL Energy Corp.

But Pengrowth too has seen a solid recovery since hitting a low of USD5.87 in late June. And that’s despite cutting its dividend from a monthly rate of CAD0.07 per share to CAD0.04 in early July. Non-Portfolio speculation Bellatrix Exploration Ltd (TSX: BXE, OTC: BLLXF) has nearly doubled since late June.

Should gas prices continue to head up into the winter these stocks will almost certainly follow. But even if they don’t these companies are now locking in the best selling prices of an otherwise dismal year by hedging. And as they’ve proven time and again they have the financial strength to outlast the price cycles in the commodities they produce.

That’s a stark contrast, however, with most companies in their industry. And that’s why it still makes sense to avoid small and more heavily indebted natural gas producers such as Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV), AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) and Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) as well as stocks of companies such as Enerplus Corp (TSX: ERF, NYSE: ERF) that have rebounded without any hard numbers to back them up.

Yes, all of these companies will have a lot further to run if gas prices do push higher in coming months. Another dip in prices, however, could prove fatal to at least one of them. There’s just no point in taking that risk, particularly when stronger companies provide just as attractive a play on a further gas rally.

Limiting leverage is also good policy outside the energy sector as we enter the fourth quarter of 2012. As of now there’s no reason not to expect the Canadian dollar to remain strong against the US dollar, or the Canadian economy to remain steady and largely free of inflation.

CE Portfolio Holdings also look set to post another quarter of strong results, as they invest to grow and access capital at record low cost.

More than a third of our Portfolio Holdings trades above my recommended buy-under targets, some by as much as 20 percent. That leaves a lot of room for disappointment. And in a market driven as much by buying and selling momentum as this one is, even the most solid-looking gain can be quickly erased.

Many investors have decided that a rising share price connotes safety, while a retreating one is a warning of imminent disaster. They pile into stocks that are going up and bail out of stocks that are losing ground. And the result is routinely jagged volatility when there’s absolutely no justification in terms of the underlying business.

As we wait on our CE companies to report their calendar third-quarter numbers, there’s undeniably a dearth of hard information. As a result rumor and opinion are what carry weight.

In the days leading up to second quarter reporting season, for example, we saw rumor and opinion jump-start panic-selling of several high-yielding stocks. Falling prices convinced other investors that dividends were at risk, leading to further selling. When the actual numbers were announced fears were quelled, and the stocks rebounded.

That could well happen again over the next few weeks. And volatility could be further exacerbated by political and economic uncertainty in the weeks ahead.

If that does happen, remember this: It only makes sense to sell if something really is wrong with a company’s underlying business. And only a company’s numbers can answer questions about its health, not an opinion that might be written by someone with an interest in a stock’s further demise. If there is trouble at a Portfolio Holding I’ll sell. Unless that happens, though, there will be a rebound.

The good news is at this point there’s no reason to expect any of our Portfolio Holdings won’t report solid results and guidance that support financial health, long-term growth and dividends. But market volatility and the danger of leverage make it critical to stay diversified and balanced.

Don’t overload on any one stock, sector or investment theme. And above all don’t overpay for any company, no matter how attractive it looks now.

That’s how to stay fully invested in what should still be a profitable fourth quarter for strong Canadian companies. And that’s how to limit your risk in case the situation doesn’t evolve quite that well.

Roger Conrad
Editor, Canadian Edge

Portfolio Update

I’m swapping Aggressive Holding PHX Energy Services Corp (TSX: PHX, OTC: PHXHF) for one of this month’s Best Buys, Poseidon Concepts Corp (TSX: PSN, OTC: POOSF).

Both are in the energy services sector, but Poseidon is less exposed to cyclical ups and downs due to the nature of the services it offers and larger size. Yields are comparable.

Portfolio Update focuses on the highest-yielding recommendations and their prospects.

Best Buys

This section, which was formerly known as High Yield of the Month, features the two top candidates for purchase in October.

This month’s choices are a current Conservative Holding, Student Transportation Inc (TSX: STB, NSDQ: STB), and a new Aggressive Holding, Poseidon Concepts Corp (TSX: PSN, OTC: POOSF).

I highlight both companies’ most recent numbers and their respective management teams’ robust outlooks for their cash flow and dividend growth. Both stocks now trade below buy targets and pay monthly dividends between 8.5 and 7.3 percent, respectively.

Buying the two Best Buys featured each month is a good strategy for starting a portfolio, provided the picks meet your own risk/reward preferences.

In Focus

October 2012 marks the 100th issue of Canadian Edge.

Since the first issue in late July 2004 we’ve had a number of highs and lows, the latter including the infamous “Halloween Massacre” of October 2006 and the historic 2007-09 credit crunch/market crash/recession. And we’ve compounded the pain at times by sticking with weak companies too long.

Despite all that the past eight-plus years have vindicated our strategy of seeking out healthy and growing companies paying generous and rising dividends and holding onto them so long as underlying businesses are healthy.

Our forecast for the next 100 issues: There’s a lot more to come for the best of the Canadian stock universe.

Dividend Watch List

No companies in the Canadian Edge How They Rate coverage universe cut dividends last month. There are also no new additions to or subtractions from the Dividend Watch List, as we await third-quarter earnings.

See Dividend Watch List for my complete list of endangered payouts.

Canadian Currents

Canada added 52,000 jobs in September, five times more than analysts forecast, confirming yet again that the Great White North is recovering faster and better than its developed-world peers. It’s yet another upside surprise up north.

Bay Street Beat–Student Transportation Inc (TSX: STB, NSDQ: STB) has posted fiscal 2012 fourth-quarter and full-year results. Here’s how Bay Street reacted, and we also summarize the Portfolio’s standing on Bay Street as the next round of reporting approaches.

How They Rate Update

Coverage Changes

We’re dropping Arctic Glacier Income Fund (TSX; AG-U, OTC: AGUNF) from How They Rate coverage this month. The company has now sold all of its operating assets and has stated it will not be able to file financial documents in Canada. There are no additions to coverage at this time.

Advice Changes

Bell Aliant Inc (TSX: BA, OTC: BLIAF)–To Buy @ 28 from Hold. The company’s dividend looks safer with its fiber build-out progressing, the financial backing of parent BCE Inc (TSX: BCE, NYSE: BCE) and competition not materializing.

That’s a far different situation from small communications companies in the US, and the yield is generous as well.

Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–To Buy @ 18 from Hold. The stock currently trades well above this level, but the franchise is solid and it would be a value on a dip.

Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE)–To Buy @ 15 from Hold. Recovering oil prices take pressure off cash flow and the distribution and the stock trades at a sharp discount to the value of its assets in the ground.

Progress Energy Resources Corp (TSX: PRQ, OTC: PRQNF)–To SELL from Hold. The company’s takeover by Malaysia’s Petroliam Nasional Berhad, better known as Petronas, has received its last needed regulatory approval and will close imminently.

Selling before close means investors won’t have to wait for the CAD22 per share in cash to show up in their accounts. US investors may also want to avoid complications that may arrive if their brokers are inexperienced in Canadian markets.

ShawCor Ltd (TSX: SCL/A, OTC: SAWLF)–To Buy @ 45 from Hold. The company’s largest shareholder says she will support a sale to the highest bidder.

Superior Plus Corp (TSX: SPB, OTC: SUUIF)–To Hold from Buy @ 8. The stock has picked up a lot of ground since late June and is due for a pause, particularly with Canadian authorities questioning some of its tax pools.

Tuckamore Capital Management Inc (TSX: TX, OTC: NWPIF)–To Hold from SELL. The company has paid off all near-term debt maturities and its operating portfolio has stabilized.

Ratings Changes

There are no changes to Canadian Edge Safety Ratings this month. Look for some next issue as we see third-quarter numbers start to come in.

Safety Ratings

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.

Resources

The following Resources may be found in the top navigation menu at www.CanadianEdge.com:

Ask the Editor–We will reply to your queries via email or in an upcoming article.
Broker Guide–Comparison of brokers for purchasing Canadian investments.
Getting Started–Tour of the Canadian Edge website and service.
Cross-Border Tax Guide–What you need to know about taxes and Canadian investments.
Other Websites–Links to other websites to help you get the most out of your Canadian stocks.
Promo Stocks–Guide to the mystery stocks we tease in our promotional messages.
CE Safety Rating System–In-depth explanation of the proprietary ratings system and how to use it effectively.
Special Reports–The most recent reports for new subscribers. The most current advice is always in your regular issue.
Tips on DRIPs–Details for any dividend reinvestment plan offered by Canadian Edge Portfolio Holdings.