Bitumen Bubble… WTIC vs. WCS

Recently our Premier went on TV to warn the public of a “Bitumen Bubble” here. Essentially Alberta’s oil is landlocked. With limited pipeline capacity and increased  American oil production (primarily in the Bakken) the prices of Western Canadian Select has decreased relative to the more traditional Texas Crude.

You can see from the video that the Albertan government was caught flat footed. They push blame to the Canadian government for poor forecasting. To me that’s like myself passing blame to an analyst for me losing money on an investment.

The Edmonton Journal does a good job visualizing the situation here.

Aside from that, the government was not alone in being caught off guard. Yours truly wasn’t paying enough attention to the potential impacts for my investments and (more importantly) career. Many companies have been cutting spending which has led to lay-offs. My company alone let go of 15% of the workforce. If you consider what the expectations were at the start of 2012, we are talking closer to 25% less staff then expected. It’s huge.

Many Albertans are still ignorant to the effects. It is actually quite amazing how little we know about what drives our economy.

Here in Alberta it is nothing new to have the price of Western Canadian Select differ slightly from West Texas Crude, but recently things have been quite interesting. Alberta production has finally started to climb and many (if not all) projects need to produce to lower the overall cost of production, even at $50. Here is a look at Alberta production courtesy of ERCB. Shown are the barrels per day.

Alberta_Oil_Production

Unless a pipeline (or even a massive rail line) is built then this phenomenon is likely to continue. The longer it continues, the further down the economy will go. The other concern is how much of Alberta’s seemingly cheap Residential Real Estate market is because it is being propped up by high wage earners in the oil sands. The potential for a domino effect is scary.

There are several ways to play this from an investing (more like speculating) standpoint. Many companies are heavily exposed to drilling activity here in Alberta. The easiest picks would be producers, but with high debt loads you would have to be very precise on timing in order for them not to do damage to the balance sheet and for earnings to rebound.

An alternative would be the drilling and service companies. This would be my preference. Many have stronger balance sheets, though some are very levered. To be clear, I do think that the only competitive advantage any have would be those that are run conservatively. Most (if not all) drillers and service companies have been increasing the amount of capital expenditures and now (for the first time since the recession) there is likely more supply than demand. This is pushing down gross margins.

The final alternative would be companies that provide some sort of service or product beyond the obvious, like mobile trailers to drilling sites or catering services to camp sites.

I don’t have an idea why so many of these debt heavy cyclicals pay dividends, I am a little perplexed. Many could continue though I think they shouldn’t. Maybe the nadir for the sector would be the cut in dividends. I don’t know how much of that is priced in at this point, but it would likely lead to some large institutional selling.

The last type of company to purchase would be one that will benefit from new pipeline development directly. I don’t have any names, but I am looking. Please send some names if you have them.

Potential Investments

I lay out the case to not immediately buy, but to scale into names when we get an announcement on pipeline or some sort of solution that oil from the WCSB will no longer be landlocked. Many have little or no analyst following, which tends to lead to a sleepy Mr. Market. I have intentionally picked more conservative companies for extra margin of safety. They may or may not rise as fast as their peers in an oil price spike. All names are Canadian listed. Many have exposure outside the WCSB as well.

Here you can find daily quotes for WCS from Suncor. Or here at the CME site.

Drillers: AKT.A, XDC, CDI

Traditional Service: SDY, SVY, NWE, FRC

Unique Service: HNL, WTA, BRY

Something I wanted to point out was the fact that I didn’t rant about our elected officials and how dumb it is to rely on oil and gas resources to be our main value proposition to the world. You’re welcome.

Dean

Disclosure: No position in anything mentioned.

6 Comments

Filed under Company Analysis, Interesting Reading

6 responses to “Bitumen Bubble… WTIC vs. WCS

  1. chip

    Dean,

    Good post. I am suspicious of the depreciation rates that some of these companies use. For example, Horizon North says their camp buildings have a useful life of 20 years, but there is no way that is reasonable. My uncle is a retired industry VP, and he said it was not uncommon to see some of these camp buildings completely destroyed after 18-24 months. Maybe the large camps are kept more like hotels, but I am suspicious of an average 20 year life.

    High Arctic Energy (HWO-T) trades at a little over 2.5X EBITDA and has a minority exposure to WCSB, and is highly exposed to Papua New Guinea. HWO kind of crosses 3 of the 4 categories you mentioned, as they do contract drilling, traditional services, and provides camp services. I think HWO might be cheap even using reasonable depreciation rates.

    Your last category of companies to look for that would benefit from new pipeline development directly would include MCR-X which has exposure to future pipeline development in B.C. and Alberta. This is a cyclical one though, there can be lean times in this industry, and it has run a lot in the last year, so not sure I would be a buyer here, but one for the watchlist. I hold a small position in MCR, and don’t own any HWO currently.

    Chip

    • Thanks Chip.
      You bring up a good point regarding depriciation rates. Another caveat in dealing with equipment in general is the likelihood of obsolescence. Many rigs that are on the books overstate the true replacement cost of the rig as they require retrofit to compete with more modern rigs. This is true for many of the rig and service companies.One needs to adjust owner earnings to reflect this. This is a potential danger when using asset based valuations where the bulk of the value lies in PP&E. Especially when day rates fall, there can be a ton of damage to the balance sheet in a short amount of time.

      Dean

  2. Michael Doumet

    Hi Dean.
    I’ve got some good small cap stock picks for you to look into. I (honestly) think most of them are two-baggers if the economy doesn’t grind into a complete halt. These are the companies (in order from best to less best).

    Loyalist (LOY.V)
    Macro Enterprises (MCR.V)
    Enterprise Group (E.TO)
    Mosaic Capital (M.V)
    C-Com Satelitte (CMI.V)

    The last one is yours, and I’ve made a decent return on it since you recommended it.

    It took me a while to build this list…but I’m feeling good about it. Good luck!

    If you’ve got any questions, fire them my way.

  3. One producer that fits this theme is Southern Pacific, (TSX:STP). They produce heavy oil in Saskatchewan and bitumen in Alberta, but they have rail capacity that they’re using to get gulf coast pricing, so the lack of pipeline space doesn’t hurt them as much as others. They do have debt, as most producers do, but I think buying their convertible debentures might be a good move. Their payments would be covered by their successful project in Saskatchewan, and the yield to maturity is 28% at current prices. I wrote about on my blog at http://www.safetyinvalue.blogspot.ca/2013/05/southern-pacific-stp-is-small-company.html

    Michael

  4. Pingback: What’s Dean been doing?? | Petty Cash

  5. Pingback: New West Energy Services (NWE.v) | Petty Cash

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