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.
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.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Cambridge Global Asset Management is a division of CI Investments Inc. Certain funds associated with Cambridge Global Asset Management are sub-advised by CI Global Investments Inc., a firm registered with the U.S. Securities and Exchange Commission and an affiliate of CI Investments Inc. Certain portfolio managers of CI Global Investments Inc. are associated with Cambridge Global Asset Management.