Oil stocks caught between a bull and a barrel

Posted on: April 23, 2012 in: Canadian Equities, Energy with 0 comments



Oil companies will likely beat expectations when they announce earnings over the next two weeks based on the recent strength in crude prices and refining margins. But even the positive surprises may not be enough to save their stock prices from being gored by a mad Spanish bull.

Canadian energy stocks had a strong start to the year. Riding a rally that began last October, the sector-focused iShares S&P/TSX Capped Energy ETF (XEG/TO) was up 9.5% year-to-date by late February, ahead of the broad market iShares S&P/TSX Composite ETF (XIC/TO) at 6.6%.

But then came Greece and its near-default on its sovereign bonds. The broad XIC fell but managed to stay positive with a 2.1% year-to-date return. The focussed XEG fell much harder, giving up its gains and ending down 6.2% for the year-to-date by last week, this despite the otherwise strong fundamentals.

Prices of WTI crude oil, the benchmark grade for North America, have averaged $97.40 a barrel over the last year, 15% higher than the five year average. There was a dip last October to $76.40 but that was brief and prices have since recovered. Producers, known in Canada as Albertans, are ecstatic.

Refiners are celebrating too. Their premium over crude on refined products such as gasoline, jet fuel and fuel oil has averaged $24.60/bbl over the last year. This “crack spread” as it’s known, had dipped to $11 last December but has since recovered to $26, more than double the five year average of $12.50.

Before you shout “Price Fixing!” or “Royal Commission!”, know that there are good reasons for the high prices, prime being my cousin Gautham in Punjab and my friend Yu Min in Beijing. Together with their compatriots, they are burning 50% more crude oil than they did five years ago. This trend is not likely to reverse any time soon.

To make matters worse, some U.S. East Coast refineries are actually shutting down production due to stagnant local demand and because their crack spread is not as profitable. These refineries rely on better quality, more expensive imported crude oil.

Ironically, the U.S. Gulf Coast has a surplus of refined product but no economical means of getting it to the East Coast. The two main product pipelines – Colonial and Plantation – that connect refining super-hub Galveston, Texas to the east coast are running at capacity. And shipping is blocked by a U.S. law that requires a U.S. crew on domestic routes. Refiners are left shipping product to Europe.

Strong prices, fat margins, tight supply, growing demand and beaten down stock prices: on their own, these factors make for a compelling argument to invest in an ETF like XEG that holds 52 Canadian crude producers and refiners.

Cheap valuations make the case even stronger. Compared to the broad XIC, XEG has a) a price to earnings ratio that is only slightly higher, b) a price to book ratio that is lower, c) a debt to equity ratio that is about half of XIC, d) a dividend yield that is comparable and e) profit margins that grew 30% this year versus 18% for XIC. The result, in the normal course, would be a strong buy.

Unfortunately, we are not in a normal course. Greece has, for the moment, postponed its default. But Spain has taken its place. Since the start of March, Spanish 10 year Treasury Bond prices have fallen to Euro 99.65 from about Euro 108 as investors seek safer havens such as German bonds. Spaniards are closing their local savings accounts and moving the money to other safer countries. Spanish equity markets are trading at March 2009 levels, having lost 21% in the year-to-date.

Spain is caught between that bull and a barrel. It must cut spending to meet debt targets. Cut too much and the economy stalls, leaving an army of unemployed youth. How Spain extricates itself from this fix over the next month or so will determine what happens with XEG and other stocks.

If Spain requires a bailout like Greece did, then all stocks, including XEG’s holdings, will suffer. But this will be temporary. For investors with a longer term perspective, XEG remains a strong buy.


Chart courtesy of Bloomberg L.P. Click on Chart for Larger Image

archerETF Metrix 20 Apr 2012
Ticker/Exchange XEG / TSX
Categories Equity / Canada / Multi-cap / Oil&Gas
Total Holdings 52
52 Week High 22.08
Recent Price 15.76
52 Week Low 13.61
Avg Daily Volume 1.4 Million shares
Avg Daily Volume ($) $ 21.6 Million
Total ETF Assets $ 822.7 Million
Allocation to 10 Largest Holdings 68.41%
ETF Annual Fee .60%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility 26.22%
Correlation to S&P TSX Comp. 91.21%
Return to Risk Ratio -1.04
Beta to S&P TSX Comp. 1.29
Price-to-Earnings Ratio 15.30
Use of Leverage No
Use of Futures No
6 month Return -5.18%
1 Year Return -25.54%
3 Year Return 3.57%
Dividend Yield (TTM) 2.67%

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© 2012 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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