Ryan Bushell

Given the significant decline in oil prices, we would be remiss if we did not address the impact on our portfolio and our commitment to the Energy sector. First and foremost, we expect oil prices to recover in the medium-term (12-24 months). The good news about OPEC’s November decision to maintain production is that this puts production cuts in the hands of North American producers; companies who manage their businesses according to economic fundamentals, not a greater political agenda. OPEC has always been a loosely aligned organization for the management of oil prices, offering little control over how much oil actually gets produced in its member states. Given production decline rates of over 50% in North American shale oil wells and the significant capital reductions rippling through the industry, it is likely that much of the marginal production growth that appeared in the past few years of strong oil prices is likely to dissipate.

Price recovery in relatively short order

OPEC has placed the onus to cut production has been placed squarely on those most likely to do so – North American producers.  However, political pain exposed by a lack of oil revenue in countries prone to civil unrest, including Libya, Venezuela, Nigeria, Iraq, Iran, Russia, Saudi Arabia and others will add additional pressure globally to cut oil production. There is also increasing the likelihood of unplanned outages due to conflict. A ~50% drop in the price of anything, especially something used as ubiquitously as oil, will stimulate demand. In a global oil market of ~90 million barrels/day, where supply is exceeding demand by roughly 1 million barrels/day (~ 1%), our research points to a price recovery in relatively short order. In fact, based on our analysis of all the factors listed above, we believe the risk is that oil prices will recover sooner than anticipated.

Focus on energy infrastructure

With regard to the Energy holdings in our portfolios, we currently have lower than market weight in companies that produce oil and natural gas, relative to the benchmark. Our overweight position is entirely in Energy Infrastructure (pipeline) holdings, which haven’t been significantly affected by the drop in oil prices. In fact, all of our pipeline holdings saw positive total returns in 2014, all of them increased dividends and we expect them all to increase dividends in 2015 as well. Unfortunately, these infrastructure providers were not immune to the indiscriminately sharp selloff of Canadian Energy shares in November and early December. These companies bounced back quickly, however, following the 33% dividend increase announcement from Enbridge as a harbinger of what could come in 2015 and beyond from pipeline companies. The oil and gas producers in our portfolio have dwindled from a nearly 18% weighting in August to closer to 11% currently. Aside from the dividend cuts already announced, we do not expect any further dividend reductions from energy producers in 2015, provided the commodity price stabilizes. In general, the Canadian oil and gas producers we have selected have low cost production, deep inventory and strong financial positions. They are built to survive temporary fluctuations in the oil price, even severe moves such as those witnessed recently. Fortunately, the complementary downward move in the Canadian dollar helps to insulate our holdings to some degree, as will price hedging and refining operations.

Dividends from resource stocks help minimize risk

The majority of the LFA portfolio is invested in “backbone” sectors, including Banks, Telecommunications, Utilities and Pipelines. It is in the Canadian resource sector where we choose to take portfolio risk. Resource-related companies can be volatile since they are vulnerable to cyclical fluctuations in the prices of the commodities they produce. These cycles tend to play out over the course of a decade. On the positive side, these resource companies pay significant dividends, which help to de-risk the investment to some extent. Think of it this way: if we have a resource stock that pays 7% yield on average through a cycle, we will get our initial investment back in 14 years, assuming the share price goes to zero. In a consumer company that pays a 2% yield, that payback period jumps to 50 years and in a technology company with no dividend… that’s where you are totally at the mercy of the market.

Commodity producers are not always easy investments to own, but neither are Technology, Health Care or Consumer stocks. They all have their own cycles, but only resource stocks pay significant dividends. As for looking to the US market as another alternative, the late 90s was a cycle where the US dollar strengthened for the better part of a decade and Technology became the largest sector in the market. This is eerily similar to the present situation. South of the border, we aren’t necessarily calling for a crash. But in our 75-year history we have repeatedly preserved clients’ capital by focusing on those companies that pay us cold hard cash.


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