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Why so few Canadian energy companies actually create value, but a few can and will

Stephen Groff's picture

I recently read the book “Capital Returns” (published by Palgrave Macmillan), which highlights how the cyclical nature of capital flows impacts returns. The punchline from the book is that excessive optimism results in elevated capital flows, which ultimately increase supply/competition but, in turn, have a depressing effect on returns. When returns are no longer attractive, capital is withdrawn resulting in lower supply/competition, ultimately leading to improved returns. Unfortunately, it is common to see excess optimism or pessimism from both investors and management exacerbate this cycle – happily supported by bankers whose fortunes are directly tied to the level of capital raised, not value created. 
We believe Canada’s energy industry provides a prime example of this phenomenon at work. Let’s start by going back to the early 2000s when energy prices began their historic upward march from a low of under US$20 a barrel in 2001 to their peak of US$147/bbl in 2008. As oil moved higher and returns for existing projects were strong (see Chart 1), both investor and management optimism increased. Investors happily invested increasing capital into the space (see Chart 2). The energy portion of the S&P/TSX Composite Index rose from 13% in 2002 to a peak of nearly 33% in mid-2008. 
Chart 1

Source: Bernstein Research

Chart 2
Source: Bernstein Research
What followed seems logical in hindsight, but was not the prevailing view at the time. As Chuck Prince, the former CEO of Citigroup said famously at the peak, “At some point the music will stop, but while it’s still playing you’ve got to keep dancing.” Elevated investment in the energy sector was occurring globally and this was particularly evident in U.S. shale plays, which were benefitting from technological changes. As this incremental supply came to the market, pricing corrected substantially. As they say, the cure for high prices is high prices. Recently, this has created further issues for many producers in Canada as there is now more supply than can economically be moved out of the basin due to pipeline constraints. This has further widened differentials or lowered selling prices for many domestic producers. 
Capital invested over this time has generated poor returns. Since August 2005 when oil first touched $63/bbl (in line with today, nearly 13 years later), the S&P/TSX Capped Energy Index has returned 1% per year (including dividends). It isn’t surprising that little value has been generated when one considers that these are cyclical, capital intensive and commoditized businesses that often receive and invest the most capital at the worst time in the cycle. 
I am rehashing these facts not to stir up difficult memories, but to highlight how this cycle can create meaningful opportunities for companies and investors alike. 
Today, sentiment is in a very different place than in 2007 or 2008. After representing 33% of the overall market at its peak, the S&P/TSX Energy Index now makes up 18% of the S&P/TSX. That said, there are a number of positive signs appearing. 
Without capital investment, industry production overall will fall; this is referred to as the decline rate and can be 30% or higher for a number of operators. This decline rate, however, is also a self-correcting mechanism for the industry. Today, capital investment in the Western Canadian Sedimentary Basin (WCSB) is contracting as many companies are now either choosing, or being forced to reduce spending, due to financial or shareholder pressure. Falling capital expenditures combined with continued base decline rates will ultimately correct the excess supply issue (along with more pipeline capacity being constructed). Ultimately this should help to reduce the selling-price discount the basin faces. Lower spending in the basin also results in less competition for labour and other inputs which lowers operating costs. 
Despite the clear challenges, we see select opportunities among companies with the following characteristics: 
1. Low-cost operations and a strong balance sheet to be able to survive periods of stress while many of their peers cannot;
2. Strong free cash flow (not operating cash flow) that is being allocated intelligently by management; and
3. A very low multiple of free cash flow (i.e. attractive valuation) using very conservative commodity price assumptions.
Free cash flow is critical in an industry like energy. Far too much capital has been poorly allocated for various reasons, resulting in weak shareholder returns for long periods of time. There will be, however, businesses to own and periods of time that create large disconnects between prices and intrinsic value. I believe we are in a disconnect today; for example, a major Cambridge holding boasts attractive growth in free cash flow per share (aided by a corporate decline rate of ~10%), is valued at an attractive 11%+ free cash flow yield*, has manageable leverage and is focused on generating maximum shareholder returns when deploying capital.
In summary, it is critical when selecting an investment to ensure management is investing capital appropriately. If investments generate insufficient returns, meaning the return on invested capital falls below their cost of capital (or ROIC < weighted average cost of capital), shareholder value is being destroyed by being invested rather than being returned. The Canadian energy industry has been guilty of this and I hope investors exert greater pressure on management teams to correct this behaviour. In the meantime, Cambridge will be doing our part by supporting businesses that create value, while shunning those that do not – all with the objective of creating value for our unit holders.
Thank you for your continued support. 

Stephen Groff

*Free cash flow is calculated using strip energy prices and assumes a level of capital expenditures required to maintain production at existing levels.

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