Co-author: Carson Tong
An essential aspect of the Signature Global Asset Management investment model is the continuous collaboration among team members that helps to uncover opportunity and limit risk across multiple sectors and asset classes. An excellent example of this process in action can be found in Signature’s approach to the energy sector throughout the recent cycle, which helped generate strong risk-adjusted returns for across the group’s portfolios.
Back in early 2014, our portfolio managers and analysts saw warning signs that energy markets were oversupplied and that oil and natural gas prices were trading about 20% above the marginal cost of production. These conclusions were based on extensive research, including numerous company visits and due diligence trips to production facilities throughout North America. We moved to reduce energy sector equity and bond weightings across our various portfolios to limit risk—positioning that worked well as oil prices started their collapse mid-year 2014. When the credit market showed signs of closing financing to the sector, we “high-graded” our energy positions, adding higher quality names such as Endeavour Energy (on the high-yield bond side) and Chevron (on the equity side).
Our underweight, higher-quality energy positioning continued to benefit the Signature funds through to the end of 2015. Then early last year, the energy markets fell into the abyss as WTI crude dropped to less than US$30/barrel. Our equity and fixed-income teams collaboratively picked through the rubble amid the ensuing sell-off to identify some great opportunities. It started on the debt side, with investment-grade bonds from issuers such as Canadian Natural Resources, Cenovus Energy and Encana that were trading in the range of 70 cents on the dollar. Recognizing that these types of bonds would recover when the market stabilized, Carson Tong and the fixed-income team initiated new positions and added them aggressively across Signature’s fixed income and diversified income portfolios. Within six months, these bonds were trading back above par and had generated equity-like returns in excess of 25-30%.
Reading the signals: Signature’s energy sector corporate bond positioning
The credit market in the energy sector started to re-open in early 2016, providing a clear signal to the equity team that it was time to re-engage with the energy names that had earlier floundered due to their leverage situation. In February, the market for high-yield energy debt was starting to heal and yet the general equity markets were still nervous about energy companies tripping bond covenants and running low on liquidity. At this time, we initiated a few new equity positions in Encana, Enerplus, Nabors Industries and Trican. This conviction stemmed from Associate Portfolio Manager Hoa Hong’s previous experience on Signature’s high-yield bond team, her understanding that the debt was well covered by high-quality company assets and that the equity would have more upside potential as commodity prices began to recover. Hoa collaborated closely with the high-yield team and leveraged her experience to confirm that the risk of covenant breaches was very low.
Between our equity and fixed-income teams we visited Midland, Texas, three times over a 12-month span through 2015-16 and talked to management teams from over 25 companies. Midland is home to the Permian Basin, the most prolific and resource-rich oil basin in North America. Through our due diligence we came to the realization that even the lowest-cost producers were not drilling new wells—a sure sign that markets were nearing a bottom. When the commodity price dropped below US$30/barrel we expected that, with time, there would be a supply response, and a rebalancing in the market would likely occur. It has since done so.
Our optimal portfolio positioning over the past energy cycle was made possible through the Signature sector specialist setup, constant communication between different asset class teams, deep understanding of the companies’ assets, strong relationships with management teams, and a disciplined evaluation process that benefited our investors. These are key elements of the Signature process.
High-yield energy outlook: Still room to run, but selectively
We've come a long way since the recent trough of February 2016, and since then we have taken some profits from a number of positions as they hit their target prices. Yields for high-yield bonds in the energy sector have compressed from just over 20% to only 6.5%, and as prices recovered we sold several positions, leaving the high-yield weights in funds such as Signature Income & Growth Fund and Signature High Income Fund virtually unchanged. We still see value in owning the bonds of high-quality energy companies in key plays such as the Permian basin in Texas and the Montney in Western Canada, both which could benefit from mergers and acquisitions activity, and have de-emphasized producers with assets in less competitive basins.
We have also invested Velvet Energy (late summer 2016) and Saguaro Resources (early 2017)—both private equity-backed liquids-rich producers—as the high-yield energy markets have healed. We felt the yield/spread differential for private debt (vs. public) was attractive given that we were able to put money to work at 9-9.5% (spread to government yields +805) vs. 7.25% (+580) for the public markets. Unlike many passive ETFs, we were able leverage off our deep relationships with management teams in the Montney basin to structure debt instruments at an attractive time. We believe these deals will yield superior risk-adjusted returns for our unitholders.
Energy equity outlook
Energy markets have recovered nicely since the early 2016 lows, with oil prices up over 70% and natural gas prices up almost 100%. Looking ahead, we believe the upside for energy commodities is more muted, and favour companies that have the capacity to grow and generate returns at prices of $50/barrel for WTI crude and $3/mcf for natural gas. In North America, these companies tend to be focused in low-cost basins such as the Permian and Marcellus in the U.S., as well as the Montney in Canada. We will look at other producing regions as well, but with a large inventory of drill-ready prospects in both oil and gas, companies must be low cost to survive and thrive in the current environment. In addition, we continue to hold equity positions in the oil field services sub-sector, as balance sheets for many producers have improved through equity issues and asset sales, and many of these exploration and production companies are ready to put capital back to work.
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.