Energy is top of mind for investors in the Canadian equity market. After all, energy makes up 19% of the S&P/TSX Composite Index, the second-largest sector after financials. And, a quick scan of the financial page headlines of our national newspapers shows the energy sector is struggling:
- “Oil prices fall 2 per cent, supply overhang back in focus”
- “Oil drops below $30, dragging TSX, Wall Street down with it”
- “Oil falls for third day as concerns about growing glut deepen”
- “‘Zombie’ stocks haunt Canada’s oil patch, but buyers aren’t biting in worst bear market in a generation”
With headlines like these, it’s understandable to question whether it makes sense to own energy companies at all, and to feel the gut reaction to sell, sell, sell! Many investors ask us to explain why the Burgundy Canadian equity portfolio holds close to 40% in energy and energy-related companies. To answer this question, here is an excerpt from our fourth quarter commentary of 2014, in which our Canadian equity team explained the Burgundy thought process for investing in the energy sector:
There are three defensible strategies for investing in oil and gas equities. First, one can choose not to invest in them at all. In Canada, the S&P/TSX Energy sub-index has outperformed the broader S&P/TSX Index over the past 20 years, and the highest-quality companies have done even better. We can thus conclude that choosing not to invest in Canadian energy companies would leave money, and diversification opportunities, on the table.
The second option is to only invest in cyclical oil and gas companies when the commodity prices are washed out and the stocks represent deep value. This is defensible because an eventual return to more “normal” commodity prices can be expected, given that industry players need to receive a certain minimum price for the commodities they are selling, in order to incent them to invest in new projects. This price level is called the “marginal cost of production” by economists, or another term for it is the industry’s “replacement price.” If a given commodity price is below the industry’s replacement price, few new projects will be developed, and these are needed to replace the industry’s current (naturally declining) production. So a low price environment, by causing a lack of necessary new projects, leads to a decline in production that eventually forces prices to recover. The cure for low prices is low prices.
The third option is to own the best, high-quality companies when oil and gas prices are near these more “normal” levels and reasonably valued stocks can be found, own none when commodity prices are well above these levels (like in early 2008) and own a lot more when they are well below, like today. This is defensible because over the long term the best energy companies have created wealth for shareholders and, as outlined above, prices that are too low will cause an eventual commodity price recovery, and prices that are too high will force an eventual collapse.
Regardless of which of the latter two strategies appears best, in both cases now appears to be the time to own a lot of oil and gas stocks in Canada. The price of oil is below US$50/barrel at the time of writing – well below the US$85-90 level that most experts feel represents the industry’s replacement price. While a recovery is thus assured, no one can predict its timing. As such, Burgundy will continue to invest in only the highest-quality companies, as well as those that represent deep value.
The industry replacement price now temporarily sits around US$70-75 (since extremely weak industry conditions lower overall project costs), but this still is almost triple the recent oil price lows. Emotions in this type of extreme market run high, yet our conviction in the investment thesis remains. We are choosing oil and gas producers with low costs and many years of reinvestment opportunities, as well as profitable service franchises, where management teams are proven capital allocators. Just as important, we are avoiding companies with poor balance sheets that will have a tough time surviving a long period of low prices.
When market participants overlook the characteristics that are fundamental to a company’s success (often because they are overshadowed by the macroeconomic concerns of the day), we are offered the chance to invest at a discount to the company’s true value. And, by investing in high-quality companies at depressed prices, our investors take a seat at the table for the inevitable market turn once that underlying value is recognized.
Times like these also serve as a reminder to think of the big picture. Many of our investors’ portfolios are constructed to include several geographies for global diversification of their overall equity portfolio. For example, an investor with a 20% equity allocation to Canadian equities, of which 40% is invested in energy and energy-related companies, would have an 8% exposure to Canadian energy. Diversification in this way can further moderate the volatility of a portfolio, thus affording the time to wait for energy to recover.
We cannot predict when that recovery will be, but this is not the end for oil. We will continue our hunt for the best investment opportunities across the globe, all the while remaining grounded in our top priority: preserving your capital.