3 VERY Different Ways to Play Canadian Energy

By
Keith Schaefer
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Alberta may not be back to its former self, but it sure looks like it is getting off the mat.

It always starts with jobs, especially in Alberta. Here the news has turned positive for the first time in years. Unemployment in Alberta dropped to 7.2% in February.

Source: economicdashboard.alberta.ca

Unemployment is now below the pre-pandemic level.  It is even below the rate in Ontario.  It may be hard to believe but unemployment in Edmonton is 6.9% – or 0.8% lower than Toronto!

Over 90,000 jobs are now vacant and available in Alberta.  This is 50% more than there was in April last year.

Other measures are showing similar strength.  Retail sales – something that had been stagnant for years – has seen a noticeable uptick in the last 6 months.

Source: economicdashboard.alberta.ca

Finally, the real estate market – again a sector that has been flat for years – is starting to turn up.

The Calgary Real Estate Board (CREB) said in February that “thanks to persistently strong sales, inventory levels in the city eased to the lowest levels seen since 2006”.

January saw 2,009 homes sold.  This compares to end-of-period inventory of 2,620.

That means that inventory in Calgary is only a little over 1 month of supply – and sales always ramp through the spring.

Edmonton real estate is a bit further behind Calgary but there are early signs of strength there as well.  According to the REALTORS Association of Edmonton (RAE), sales in January were up 13% YOY.

It is no secret what is driving the upswing.  As much as Alberta is trying to diversify its economy, the economy still goes as energy prices go.

Today, with WTI over $90 and natural gas over $4, the outlook is looking better than it has in a long time.

I expect the bonuses in Calgary to start hitting bank accounts right about now.  After years with no bonuses, I expect employers to richly reward to their staff.

Put it all together and it is time to look at Alberta again.  Especially companies tied to Alberta real estate.

I’ve come up with 3 names for you – one mid-cap and two small-caps.  Two of these names have direct ties to the real estate business, while the other stands to benefit from a return to normal and a better Alberta economy.

 

Boardwalk REIT

 

Living in Vancouver, I am no stranger to a strong real estate market.  House prices and rents in Vancouver seem to only go one direction – up.

That strength, which has traditionally been centered on the lower mainland and the GTA, broadened out last year to cities like Montreal, Ottawa and Guelph.

This year it looks like that will extend to the Prairie provinces, with Alberta being the first in line.

Boardwalk REIT (BEI.UN – TSX) is my mid-cap play on Alberta.   Call this the safe way to play the boom.

Boardwalk was founded as a Calgary-based apartment REIT in 1984.  While they operate rental apartments across Canada, more than half of their footprint lies in Alberta.

Source: Boardwalk December Investor Presentation

Boardwalk operates a simple business.  They own apartments, usually centrally located in medium to large cities, and they rent out the suites.

What I like the most about Boardwalk is that it’s not obvious how cheap it is.

A quick scan of brokerage reports shows that Boardwalk (BEI in the chart below) scans middle of the pack in terms of net-asset-value per unit.

Source: RBC Capital Markets

But this comp misses the point (something RBC to their credit recognizes, giving the stock an Outperform).

NAV is calculated on past sales.  In Alberta, apartment prices have been depressed for years because Alberta’s economy has been in the dumps.

But this is beginning to change. 

Boardwalk showed the following slide in their investor presentation.   You can see the difference between where the stock price is and where the unit NAV would be if their whole portfolio traded at the price of recent real estate transactions.

Source: Boardwalk REIT December Investor Presentation

Sales prices of rental properties are rising for one reason – it is a much tighter rental market than it has been for years. 

When oil prices swooned and unemployment in Alberta shot up to double-digits, Boardwalk was making concessions.  They were offering a free month to new renters.

But now occupancy at Boardwalk is back to 96-97% at the Q3 seasonal low-point.

That means rent concessions are a thing of the past.  Going forward Boardwalk should benefit from gradual rent increases.  In Alberta, unlike much of Ontario and BC, there are no rent-controls.

We are already seeing this happen.  In Q3 incentives declined and new lease spreads, which is the monthly rent of a new lease compared to the rent of the lease it is replacing, turned positive for the first time in years.

Source: Boardwalk Q3 Investor Presentation

Meanwhile prices have plenty of room to rise.  Rental affordability in Alberta is better than anywhere else in Canada.

Source: Boardwalk Q3 Presentation

Maybe most important, Boardwalk is seeing a growing trend of “move-ins”.  These are out of town renters.  Boardwalk described on their call that  they are seeing “more Canadians move back to Alberta and Saskatchewan”.

Source: Boardwalk Q3 Presentation

REITs trade on a metric called capitalization rate, or cap rate for short.  Cap rate is essentially the net operating income of the company divided by its market capitalization.

At $55, Boardwalk is trading at a cap rate of 4.84%.

Source: Boardwalk Q3 Presentation

This is a big discount to their Eastern peers, where the cap rate averages in the mid-3’s.

That made sense when oil was in the dumps and unemployment in Alberta was near double digits.

Not as much now.

Consider that when oil boomed in the early 2010’s cap rates in Alberta were below Ontario and Quebec.

I don’t know if we get all the way back there, but I think it’s a decent bet that the gap narrows.

 

Big Rock Breweries

 

My second name and first small-cap gets away from the real estate theme.  Big Rock Breweries (BR – TSX) stands to benefit from western prosperity and a truly “open” summer.

Big Rock operates breweries in Calgary and Vancouver.  The company started in Alberta and it remains the core of its business.

Big Rock has had a tough go of it since 2014. 

Source: Big Rock Breweries Investor Presentation

In 2014 the oil industry was booming.  Big Rock was the premier name for beer and Alberta was just the sort of place that drank a lot of it.

But then came the headwinds.  The oil prices collapsed.  Competition came from newly minted craft brewers.  And then the biggest hit of all – the beer tax.

It wasn’t called a tax.  It was a “mark-up”.  Different sized brewers pay different sized mark-ups to the Provincial Government for each beer they sold.

In March 2015 the NDP announced changes to the mark-up which lumped Big Rock in at the same fee rate as large brewers like Molson Coors and Heineken.

Suddenly Big Rock was uncompetitive.  They were being treated like a big player but they had small player costs.

Retailers passed through the higher rate to consumers.  Big Rock beer was suddenly more expensive.  Sales slipped.

Big Rock tried to maintain their market share by reducing their wholesale price.  But that destroyed their margins.

Big Rock’s EBITDA margins, which had averaged mid-to-high teens from 2010-2013, fell to 4-6% in 2015-2017.  The stock cratered from a high of $19 to under $5.

At the end of 2019, with a Conservative government in place, Big Rock finally got a reprieve.  In October of 2019 the Conservatives announced a reduced and more graduated markup, one that meant a reduction in Big Rock’s fees to the Alberta Gaming, Liquor and Cannabis (AGLC) of close to 50%.

That alone could have started the turnaround.  But of course, we all know what happened shortly after.  COVID hit, restaurants and pubs closed down and oil prices tanked.

While the Alberta economy did poorly in 2020, Big Rock was still able to take advantage of the reduced mark-up and begin to right the ship.

EBITDA margins recovered back to the double-digits (still well below the 2010-2013 level).  Sales began to grow even as keg sales (sales to restaurants and bars) did not.

Flash forward to today and Big Rock has several things going for it.

First among them is that Big Rock is no longer constrained by paying large fees to the AGLC.  A quick look at the numbers shows how those fees hammered the company for nearly 6 years, and how their removal coincides with the start of a recovery

Source: Big Rock Financial Statements

Second, Alberta has been first to rip off the pandemic restriction band-aid.

Big Rock should see on-premise sales ramp again.  Keg sales help both top and the bottom line because packaging costs of kegs are lower than bottling and canning.

A truly “open” summer season would also benefit Big Rock as it would mean a tourism revival and more visitors to big beer drinking events like the Calgary Stampede.

Third, the rising oil price is bound to buoy Alberta sales.  Alberta booms coincide with more corporate events, more lunches out, and more alcohol consumption.  Albertans seem to understand that their booms won’t last.  They do their best to take advantage of them while they can!

Big Rock trades at a discount to their closest peer in the public market Waterloo Brewing (WBR – TSX), a brewery serving the Ontario market.

Source: Company Documents

But really, Big Rock should trade at a discount to Waterloo Brewing.  Waterloo Brewing has been consistently delivered higher margins and better cash flow than Big Rock.

Over the last 5 years it has been the better operating company – hands down.

But there is another way to look at it, and that is the idea I have here.  Big Rock is a classic turnaround.  Big Rock has seen all the headwinds I mentioned above.  And those headwinds are disappearing, one by one.

If Big Rock can take advantage of these tailwinds, the stock has some catching-up to do.

 

Genesis Land Development

 

For my final pick I’m heading back into real estate – this time to home building – with Genesis Land Development (GDC – TSX).

Genesis is a home builder in Calgary.  That’s right, they only build in Calgary and its surrounding area. 

I know, its odd.  When I came across this company, I scratched my head and asked – why is this company public at all?

But it is.  Genesis generates revenue from land development and selling homes.  Forward orders of homes drive future growth.

Genesis owns land and lots throughout Calgary and Airdrie.

Source: Genesis Land Development Investor Presentation

They own 681 acres of land in Calgary.  That land has the potential for 4,577 future lots.  In the last year Genesis has been adding more lots, 240 of them, which they purchased from 3rd party developers.

Genesis is currently building out houses in 5 communities in Calgary in addition to those 3rd party communities.

Source: Genesis Land Development Investor Presentation

That gives them a big runway of inventory.  Genesis sold 225 lots and homes last year, they will do 250+ this year.  Current inventory is enough for nearly 20 years of home sales at the current build rate.

But I suspect the build rate is going to rise.  We are seeing that already.  In the first 9 months of the year Genesis saw a 22% YOY increase in home orders, from 138 to 168.

That has put the outstanding inventory of home orders well above the levels it has been for the previous couple of years.

Source: Genesis Land Development MD&A’s

Genesis did a rights offering in December, raising $30 million at $2 per share.

Two things about this offering.  First, there was HUGE management participation – 11.3 million shares went to directors and management (they were already big holders of over 65% of the shares).

Second, Genesis doesn’t seem to have needed the money.   They had $29 million of cash at the end of Q3.  That makes me think Genesis is expecting to either ramp their home building or make some large land purchases.

Like my other two picks, the stock is trading on the Alberta of the past few years, not the Alberta of the next few.

If I’m right, returns will accrue via dividends.  Genesis pays out a dividend that has varied a lot over the years depending on the performance of the business.   It has been as high as 46c per share in 2017 and was nil in 2017.

Source: Genesis Land Development AIF

So far this year Genesis has earned 16c EPS in the first 9 months.  That puts the stock at about 12x earnings.

Another way to look at the stock is on the value of their real estate holdings.

Genesis carries their land at the lower of cost or fair value.  At the end of Q3 Genesis held $210 million of real estate on their balance sheet. 

Real estate is the main balance sheet asset.  It is the primary contributor to the book value of $235 million (they also have $21 million of debt and ~$59 million of cash post rights offering).  Genesis has a market capitalization of $146 million. 

That pegs Genesis at ~0.62x book, which seems awful cheap given the tightness of the Calgary housing market.

I have anecdotally heard of other Calgary builders (not Genesis) raising prices on new homes $25k per month the last few of months.

My back-of-the-napkin math suggests every $25,000 of price increase would mean an extra 10c EPS to Genesis on an annual basis.

While there is no guarantee Genesis will realize those kinds of gains, if they did, the stock, which is already reasonable, begins to look extremely cheap.

So there you have it.  Three plays on Alberta.  You put it all together and Genesis, like Big Rock and Boardwalk, look well positioned to take advantage of a recovering economy in Alberta.  It is something to be hopeful for, because right now Canada needs all the good news it can get!

IS GOLD MINER M&A ABOUT TO TAKE OFF?

By
Keith Schaefer
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The commodity bull market is in full swing.

Oil, copper, nickel, corn, soybeans –commodities have been on a steady move up over the past few weeks.

The last one to the party has been gold. While the others took off, gold bounced around the $1,800 mark and made me wonder if it was ever going to join in the fun.

Source: Stockcharts.com

But the move we saw Wednesday was reassuring. While not a confirmed breakout, the action of the miners certainly leads me to think it is only a matter of time.

Big moves always start with the biggest miners and that was what we saw this week: Newmont (NEM – NYSE), Barrick (GOLD – NYSE), and Agnico-Eagle AEM – NYSE) were all up huge on Wednesday. 

Source: Stockcharts.com

 

Breakouts from the Top Down

 

If this moves gains steam we should be in for some fun.  The combination of rising gold and depressed mining stocks could lead to a bonanza of mergers.

Mergers always seem to begin after the bottom. I’ve seen it cycle after cycle. No one wants to buy at the top and no one wants to buy when prices are still falling.

Mergers begin after the turn when the bottom is in.

The stock prices of the majors always move first. Then they use their currency (their stock) to buy up smaller fry.

We’re not there yet. Not even close. The big miners have a lot of room to move up first. The big miners are not really that expensive – especially given where the rest of the market is.

Consider the most expensive of the bunch: Newmont. Newmont expects cash flow of a little under $4.5 billion in 2022. That is an 11x multiple. Agnico-Eagle is at 10x. Barrick is only at 7x.

Much of that cash generated by the big-caps is free-cash-flow.  Newmont delivered $2.3 billion of free-cash-flow in the first 9 months of 2021. Estimates are for $2.5 billion+ of free-cash-flow this year.

Newmont, Barrick and the rest have cash to spend. If they want to put it to work in M&A, they don’t have to look too far.

Kinross Gold (K – TSX) and Yamana Gold (YRI – TSX) are both large producers trading at far lower valuations.

Kinross, a 2.6-million-ounce producer, is expected to have a $1.50 per share of cash flow this year (consensus estimate), growing to $1.65 next year. With the stock at a little under $6, that is just under 4x cash flow. 

Yamana trades at 4.8x cash flow and will produce 1 million ounces of gold (flat -year-over-year). At a $5.50 share price, Yamana has a free-cash-flow yield of nearly 8%.

 

Acquisitions for survival

 

But these companies could become acquirers themselves. Yamana is a microcosm of the industry. Yamana has a 10-year growth profile that is essentially flat. To break out of this funk the company has two choices: acquire of be acquired.

Source: Yamana Investor Presentation

The same goes for the group. The eight largest gold producers are expected to grow production by only 4% this year, followed by 5% next year – and that assumes everything goes as planned (this is mining after all).

Source: Analyst Consensus Estimates

These senior miners need acquisitions to grow.

Unfortunately for them, the set-up for acquisitions could be better. But for investors it looks great.

That is because the problem isn’t price. There are cheap stocks out there. It is just that the mining universe has shrunk so far.

Bank of America Capital Markets put together an interesting report last week called “2022 gold M&A outlook: The race to replace gathers pace”. 

In the report they made a list of the most attractive small and midcap targets for the large miners:

Source: Bank of America Capital Markets

It looks like a nice list of prospects. But the number of companies on the list far less than the number that have been acquired over the last few years:

Source: Bank of America Capital Markets

Not a great situation for acquirers but a good one for the savvy investor.

But its not all bad news for miners on the hunt for acquisitions. What is working in their favor is that the stock price of the small-fry are trading very cheap.

 

VICTORIA GOLD – A GREAT FIT FOR A BIG MINER

 

Take the #1 stock on the list: Victoria Gold (VGCX -TSX). Victoria is a single mine producer in good political jurisdiction. Their Eagle Gold mine, in the Yukon, has been ramping up since the end of 2019.

Eagle did 160,000 ounces of production in 2021. In the third quarter Victoria sold 53,000 ounces at $960 AISC. The Q4 production numbers, which came out two weeks ago, were a bit shy of 50,000 ounces.

Eagle is a cash flow generating machine. In Q3 Victoria generated $32 million of free cash flow from Eagle. With a $950 million market cap and $200 million of debt, the stock is trading at only 10x annualized FCF.

Yet Victoria’s stock price has been hit.  It had a high of $19 in November but has fallen to $15 today for the usual reasons – management overpromising on a newly minted mine.

Quite honestly, single mine producers would be better off not saying anything. When they give guidance they just seal the fate of their share price.

At the beginning of 2021 management forecast that Eagle would produce 180,000-200,000 ounces in 2021. Of course that was reduced to the “low end” late last year.  To the surprise of virtually no one, actual full-year production came in even lower – at 164,000 ounces.

But here’s the thing.  The mine is still hugely profitable.  We have two quarters of 200,000-ounce annualized production.

Rolled up into a larger company and Eagle’s bumpy path to sustainable production wouldn’t be under the microscope.

Victoria trades at half the NAV5 of Eagle and Eagle should get bigger yet. There is visibility to at least 250,000 ounces, which Victoria has forecast for 2023 and plenty of exploration upside.

 

WESDOME – KIENA UPSIDE KEEPS GROWING

 

#4 on Bank of America’s list is Wesdome (WDO – TSX), a Canadian producer with mines in Ontario and Quebec.

Wesdome is more expensive than some of its peers – it trades at 8x 2022 cash flow.  But the premium is justified by the drill results Wesdome has been releasing.

Wesdome produces from two mines: Eagle River, which has been on production for years, and Kiena, which began to ramp up production in Q4.

Wesdome released 2022 guidance last week, forecasting 160,000-180,000 ounces of production, with 40% of that coming from Kiena

Source: Wesdome January 14th Press Release

But the drill results at Kiena are screaming that much higher production is possible.

In May, Wesdome announced a truly phenomenal drill intercept at the Kiena Footwall Zone: 41.2 g/t Au over 51.2 m core length. That is more than an ounce of gold over a length of close to half a football field.

Since deciding to focus on Kiena 3 years ago, Wesdome has delivered press release after press release outlining high-grade ore over long lengths.

Kiena is an old mine that Wesdome is bringing out of care and maintenance. While Wesdome ran the mill at Kiena at ~400 tonnes per day in Q4 2021, that old mill has the capacity to operate at a much higher throughput.

Wesdome’s 2022 guidance for Kiena suggests the mill runs at ~500 tonnes per day as Kiena ramps to commercial production in Q2.

The medium-term plan is to run the mill at 850 tonnes per day. But with the drill results we keep seeing, I have to think the longer-term hope is much higher. The mill capacity at Kiena is 2,000 tonnes per day.

Combine this with recent drill results and it is possible that Kiena becomes much bigger than what is baked into 2022 guidance.

 

WILL 2022 BE THE YEAR OF GOLD M&A?

 

In their year-end gold miner note, Credit Suisse pointed out that gold miners were one of the few sectors in the market to “screen inexpensive”.

The bank highlighted that the miners are just plain cheap: “trading at multiple well below the last gold bull market in 2012”.

Like Bank of America, Credit Suisse also expects more M&A. In addition to majors looking to grow reserves, they see more combinations among intermediate producers looking for scale.

What I know is that the number of new gold discoveries that pop up on my watch-list declines every year.  And apart from a brief uptick in the summer of 2020, the money going into juniors for exploration has been sparse.

That combination can only mean one thing. If you need to find ounces, you are going to have to buy them.

Time to pay up!

A RARE HOSTILE TAKEOVER IN CANADA GOLD ROYALTIES GROY-NYSE VS ELEMENTAL ROYALTIES—ELE-TSXv

By
Keith Schaefer
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Gold Royalty (GROY-NYSE) has been on an M&A tear, buying up several small illiquid gold royalty plays on the exchange. 

Now they have made a HOSTILE bid for ELE. Hostile bids are very rare.

The GROY team is my newsletter colleague Marin Katusa, Amir Adnani and David Garofolo (ex CEO of Goldcorp when it was bought by Newmont) who put together GROY-NYSE as a blind pool ($90 million!!) to go out and consolidate this group, and they have done a very good job. Marin is a financial genius, and Garofolo has the operating background to make this all work.

But like ELE, the GROY stock has done very little in a Market where no one cares about gold, and especially doesn’t care about junior gold stocks of any kind. The charts of both stocks are quite flat and boring.

GROY have now offered to buy ELE at $1.75 a share in an all-share transaction. They (oddly) broadcast this intention publicly before making an official offer.

For GROY this is a no brainer. They have a market cap of roughly 100x revenue ($7 million, and ELE is trading at 10X ($11 million). YES, ELE actually has more revenue!!

ELE would be their crown jewel. Elemental’s big royalty kicks in NOW—ELE’s first big cheque from that royalty comes in January. So it’s a perfect time for GROY to make this opportunistic bid.

The GROY team is not stupid. They know that 10 shareholders make up 70% of the ELE stock. 

Chairman John Robins just sold another of his companies, Great Bear (GBR-TSXv) to Kinross (KGC-NYSE/K-TSX) for US$1.4 billion. Many GBR shareholders are also ELE shareholders. So nobody needs any money.

With such a tight shareholder group, the GROY team must have had some behind-the-scenes chats with independent shareholders or a few of these key shareholders before making a bid–or why would they bother? Otherwise, all this is is FREE PUBLICITY for Elemental Royalties, broadcasting to the world that this is a great company trading incredibly cheap.

So somebody in that tight group must have encouraged GROY. Now, one of them is Aussie-listed South32 (ASX:S32) which was spun out of Aussie mining giant BHP back in 2015.

They sold their producing royalty to ELE because ELE was small and illiquid (meaning they thought the stock had great upside a few years out).

In fact, Robins has his own royalty company–Great Bear Royalty (GBRR-TSXV). That stock has gone up with the Kinross (K-TSX/KGC-NYSE) takeover of Great Bear at CAD$29/share.

Great Bear has a large high grade deposit in the prolific Red Lake district of northern Ontario. While it is years away from production, it would arguably be a very complementary asset to merge with Elemental–as

Elemental has cash flow royalties from producing assets in Africa and Australia. A development stage asset in North America would add some diversity.

Except ELE wants to buy producing royalties, not development stage assets that are years away from generating cash flow. But Great Bear has a great shot at being a BIG mine–in a first world country. So that option is up in the air.

Of course, if GBRR did make a bid, it would need a fairness opinion and everybody associated with Robins would not be able to vote.

The management team at Elemental Royalties has done everything shareholders could ask—but the Market does not care about junior gold stocks at all, and hasn’t since ELE listed. (Gold is looking better this week though!)

Not only is the stock flat, it barely trades at all–which, as a shareholder myself, I can tell you is really annoying! But ELE’s stock is too tight, and has too much insider control. Up until GROY came along, the Market clearly thought the takeover potential was very limited.

GROY is taking advantage of that.

The mining and mineral exploration industry is VERY small–all these management teams know each other well, and have for a long time. (Katusa and Robins actually have their offices a few floors apart in the same Vancouver office tower–how’s that for an awkward elevator ride????) And the same goes with the funds & large retail shareholders that own these stocks.

So this is a bit personal for everyone involved.

Adnani and Katusa et al specifically set out to give the GROY shareholders the best shot at making Big Money (heads up-I’m a paying subscriber of Marin’s). He brought in Garofolo, and got GROY listed in the US–to better offer liquidity and upside to his shareholders.

That’s exactly what us ELE shareholders want! But to me, ELE is worth a lot more to GROY–with a much higher valuation on lower quality assets–than $1.75. ELE has more revenue than GROY! And their big royalty kicks in this quarter!

Great timing for GROY–and now gold is looking brighter. But I’m fairly certain this bid is just Round 1. Will there be a slightly higher bid with a bit of cash? Or will there be a 2nd bid from another company.

It’s a no-lose situation for me as an ELE shareholder.

I rarely love drama in my investing life. But I’m going to love watching this take-over battle play out.

WHAT IS DRIVING THE BULL MARKET IN POTASH PRICES? and will it continue?

By
Keith Schaefer
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0

Last week and this week I look at two ag commodities–phosphate and this week — POTASH. Prices are soaring–but is this the peak of the cycle?

If you only looked at the supply and demand of the potash market, you would come away thinking its balanced.

Potash demand is expected to come in at ~73 million tonnes this year. Capacity is about 83.5 million tonnes. Operating rates are ~87%. That looks balanced.

Yet prices tell a different story.

The global spot price for potash is $600/t to $800/t.  It has more than doubled year-over-year!

It begs the question…

WHAT IS GOING ON?

 

Why are prices going through the roof in what appears to be a balanced market?

Simple. Potash is not your average market.

Potash supply is dominated by three big players.

In Canada, Mosaic and Nutrien together form a potash export alliance, called Canpotex. Together they represent 40% of the market.

In Russia and Belarus, two state owned producers, Uralkali and Belaruskali, together hold another 33% of global production. For years, these two producers had a partnership as well – at the time there were only two big players. But their partnership broke down in 2013.

Still, there are few markets where 3 big players contract 70% of supply.  When you have such control, you’d be crazy not to take advantage of it. 

They do just that. While Canpotex produces about ~30 million tonnes per year (in a 75 million tonne market), BMO Capital Markets estimates there are another 4-5 million tonnes that they are holding back.

The potash market is indeed balanced – because the producers make sure of it.

 

DEMAND IS STRONG!

 

With producers keeping a tight rein on supply, it takes only a little incremental demand to drive prices up.

That is what we’ve seen over the last year. A COVID catch-up in inventories and higher grain prices that have led to more planting.

Nutrien CEO Ken Seitz recently told RBC Capital Markets that “Nutrien is sold out through 2021 and already booking volumes for 2022”.

Strong demand should continue into 2022. Next year will see a continuation of the catch-up – mostly from China and India.

The story of 2021 has been one of two competing narratives. Demand from Brazil and the United States has been strong – imports this year at all time highs. But China and India demand has been muted, still well below the level of 2019.

Source: BMO Capital Markets

The India and China contracts for 2022 will be important. They negotiate as countries on behalf of their farmers so prices are set for all imports coming in.

Nutrien’s Sietz believes those contracts will be settled at the typical “moderate” discount to Southeast Asian spot – which is around $600/tonne.

That will be a big move up from the last contract – which was done at $285/tonne.

But Potash producers have to be careful. They want to raise prices as much as possible, but not to go too far. Because potash has an Achilles heel.

DEMAND DESTRUCTION

 

I’ve played the potash cycles a couple of times, and I have learned the hard way that potash demand can be fleeting.

Producers like to point out that potash is only a small part of input costs. That may be true, but when squeezed farmers will still cut where they can. The reality is that they can cut back on potash.

Potash is the weak sister of the fertilizer trio.

Nitrogen is the fertilizer that plants can’t live without. Plants need nitrogen to grow leaves. They need leaves for yield. Farmers can’t cut back much on nitrogen.

Phosphates – you have a little more wiggle room.  A farmer can skimp a bit, but because phosphate encourages root growth, nutrient uptake, if you skimp too much it will directly impact the yield of your crop.

But potash… well, the yield impact, at least in the short run, is not so clear. Potash is all about improving the robustness of the plant.  Unlike N and P the K doesn’t directly drive yields.

That doesn’t mean you can neglect potash all together. But it does mean that if prices get too high, you can take a step back on your purchases, rely on the potassium in the soil and rest on your laurels for a season.

Why does this matter?

Fertilizer prices are expected to take a big bite out of farm incomes next year.

Farmdocdaily gave a good perspective. In the chart below they showed farm income at two different fertilizer price levels – the 2021 level and the expected level for 2022. 

Source: farmdocdaily

According to their data, “higher 2022 fertilizer costs reduce net income by 34%, a substantial drop.” And as you can see, if crop prices begin to fall, farmers could be looking at a loss.

Farmers are running those numbers as well. Potash will be one of the first things they cut back on.

 

INVESTORS–BE WARY OF RE-BALANCING

 

Unlike the phosphate market, where new supply is still sometime away, the potash market will see growing supply next year.

Mosaic is expecting to add 2 MT of production beginning in Q1 of 2022. Nutrien is expected to maintain its high level of production.

Nutrien is restarting its previously idled Vanscoy mine and increasing capacity at the Allan, Corry and Lanigan mines.

Longer term, BHP is spending $5.7 billion to finish a huge potash mine in Canada.

It is difficult to point to a true shortage of supply.

 

POLITICS CAN CAUSE SUPPLY DISRUPTION

 

There are other dynamics underpinning the market.

Even though the Russian cartel is dead, right now the Belarusian producers threaten a different sort of disruption.

In April the United States issued sanctions against Belarus in response to the government’s “campaign of repression to suppress democracy”.

So far, the sanctions only affect the state-owned producer, Belaruskali OAO – not the semi-private Belarusian Potash Co. So the impact has been muted.

But if the sanctions broaden out, that could have an impact on the market. 

It may be already. From what I can tell, no one is really sure how much the sanctions, or threat of sanctions, are impacting demand for BPC potash. Consider this statement from RBC Capital Markets, which sums up the way the analyst community talks about the sanctions: “The extent of governmental restrictions on BPC remains unclear but concern over their magnitude provides stability to pricing.”

 

STRONG PRICING…FOR NOW

 

The combination of managed supply, sanctions on Belarus, and strong demand from India and China are going to keep the price of potash up for at least another year.

I wouldn’t get your hopes up for even higher prices though.

This has been a really big move. Potash prices are now back to the lofty level they were at 15 years ago.

There is no noticeable supply deficit. Global inventories aren’t at all time lows. It doesn’t really make sense for potash prices to have another leg up.

Instead, expect Mosaic and Nutrien to do their best to hold the line, managing potash prices at around current levels and trying to establish a new normal.

They stand to make a lot of money on potash if they can keep prices levitating. They will likely be happy to do just that. 

 

EDITORS NOTE–food prices are soaring. The West now wants its own secure food supply chain with no potential for disruption. One of my favourite junior stocks–well under $1/sh–is a vertically integrated legume company which has just announced its first major product launch into the highly profitable snack food market. I think 2022 will be its best year ever–for both the company and the stock. Get my full report right HERE.

PHOSPHATE PRICES ARE HIGH ALREADY..WILL LFP BATTERIES TURBO-CHARGE THEM EVEN HIGHER?

By
Keith Schaefer
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0

With supply issues and politics, agriculture stocks are a legitimate investor trend now. From upstream farming & fertilizer stocks to downstream grocery stores (are you seeing the food inflation numbers right now??) the Market will be paying a lot more attention to this sector for a few years.

This week and next I’ll share some of my research with you on upstream fertilizer stocks–both physical and on the exchange! Prices for the commodities are at 8 year highs, but what about the stocks on North American exchanges?

This week is PHOSPHATE. Next week is POTASH.

Commodity prices have had a great year. Oil, base metals, agricultural products–are all up. The junior stocks in these sectors have also had a fabulous year (first half of the year anyway)–but ag stocks not so much. Could they be the next big mover–or is this sector already peaking?

Today I take a quick look at phosphate, a fertilizer. I am long a couple phosphate stocks, but only in a small way.

Like oil stocks two years ago, this sector was left for dead. Yet not only is its pricing up BIG this year, it has a potential extra catalyst–Electric Vehicle (EV) batteries. Tomorrow I’ll give you some thoughts on potash, another fertilizer.

Phosphate is a key fertilizer ingredient. N-P-K – P is for phosphate (the N stands for nitrogen, and K for potash). Plants need all 3 of these to grow to their potential.

This year, the prices of all three fertilizer inputs have all been going through the roof. But it is phosphate that has really caught my attention. 

Source: BMO Capital Markets

Short-term, prices of phosphate are being driven up by India and China, where supply is short. But phosphate is a commodity. These sorts of imbalances are bound to correct with lower demand and new supply.

In the past this has certainly been the case. Roughly 85% of the world’s phosphate ends up in fertilizer. If phosphate prices rise too far, farmers cut back on usage. While demand for phosphate has been broadening out – it is now used as a preservative in food, in pharmaceuticals and in detergents – it is still fertilizer that drives price.

What might make phosphate different this time is that there is increasing adoption of lithium-iron-phosphate batteries, particularly in China. A new source of demand that – if it’s large enough – could send the entire price structure for phosphate to a new level. (At a minimum, it should increase the price at the margin.)

To determine if this is the case, we need to dig into the details.

 

Inventories Already Low As Covid Hit

 

China is the biggest player in the global phosphate market. China produces nearly 60% and it is the world’s largest exporter. China’s exports are on the order of 10-11 million tonnes annually.  

Source: BMO Capital Markets

This compares to phosphate demand of ~75 million tonnes.

Source: BMO Capital Markets

What is driving phosphate prices this year is partly because of China and partly global demand.

Like everything else, it starts with COVID. The world had low inventories in Jan 21 due to COVID uncertainty. As the economy has bounced back, there has been a rush to restock—especially in Brazil – a large agricultural producer – where imports have surged this year.

Brazil and India are the two largest importers of phosphate. But as you can see from the chart below, India demand has not surged this year:

Source: BMO Capital Markets

The reason is fertilizer import subsidies. Lower subsidies (determined by the Indian government) have led to negative margins for importers. With little incentive, no surprise that imports drop.

The result is what RBC Capital Markets describes as “critically low phosphate inventories” in India.

These low inventories should keep the phosphate party going in 2022. Mosaic expects increased Indian demand next year:

“Given how depleted Indian inventories are, we see India as a source of pent-up demand, which should return to the market in 2022.”

 

Now China and Russia Are Restricting Exports

 

Meanwhile China and Russia are squeezing supply – pausing their export of phosphates.

On their Q3 call, Florida based Mosaic (MOS-NYSE) said “Chinese exports are expected to decline significantly in the fourth quarter and in the first half of 2022”.

The mandate for reduced imports comes from the top down – China’s National Development and Reform Commission.

Asked on the call where they thought China exports would be next year, Saskatchewan-base Nutrien (NTR-NYSE/TSX (the old Potash Corp)) management replied a “range of 8 million to 9 million tonnes sort of similar to where they were in 2020, is likely a realistic level given the increased constraints.”

Compare that to the 10-11 million tonnes of the past, and it’s another reason to think phosphate’s strength has some legs.

It is similar in Russia. Canadian brokerage firm Scotiabank recently wrote that “Russia will tighten export controls of nitrogen, phosphate, and NPKs, likely through May 2022.”

Meanwhile, new phosphate supply is not on the horizon. There are some small additions coming from Morocco and Saudi Arabia, but not enough to fix the market overnight. 

As a result, pretty much every analyst expects the phosphate tightness to continue into 2022. But the question that nobody can answer is–is this just a regular cyclical peak. Most analysts have phosphate prices back down to the historic average by 2023.

I think there is definitely a 1 year TRADE in these phosphate stocks, but can there be a multi-year TREND here?

 

Phosphate for LFP Batteries:

THE NEW DEMAND DRIVER?

 

The question is – can LFP demand be that driver?  Will demand be high enough to extend the shortage, and if not, will it eventually be enough to impact the balance?

BMO Capital Markets does not think so. In a research note written in September, BMO concluded that “incremental LFP-related phosphate demand in 2030E” would be “well less than 1Mt, less than 1% of 2030E forecast phosphate demand.”

The BMO analysis is based on 10 million electric vehicles in 2030. They assumed phosphate was 20% of the cathode weight and that the cathode weighed 2 kg/kWh and a 45kWh LFP pack size.

I checked their numbers. They seem reasonable. By comparison, US brokerage firm Bernstein estimates that phosphorus makes up a little more than 10% of the ~2.5 kg/kWh LFP weight right now. Morgan Stanley estimates a 2.2 kg/kWh cathode weight that is less than 15% phosphorous.

That is not a huge number–but it might not take much new demand at the margin to keep prices higher for longer. There is some disagreement among the analysts. The largest Canadian broker—RBC Capital Markets—recently said that:

“Increasing adoption of previously overlooked lithium iron phosphate (LFP) batteries in China, and potentially in other regions including the US, may be another long-term growth driver… if growth tracks general market EV growth expectations (~20% CAGR), this dynamic could result in a much tighter long-term phosphate S&D dynamic than we currently anticipate.”

Unfortunately, RBC has yet to provide the data, at least publicly, to back up this point of view.

 

Regular Cycle Peak or Do We Get An Extended Peak?

 

The bottleneck appears to be the iron-phosphate manufacturers. A recent article from SMM News pointed out that producers “are running at full capacity amid saturated orders and no longer accept new orders”. Prices have jumped as a result.

Unfortunately, the iron-phosphate business is almost entirely in China.

At first glance, the LFP demand scenario does not appear to be a huge game changer for phosphate prices; i.e take them to higher highs from here.

But supply is already so tight, any increase in demand could extend the cyclical peak in pricing we are seeing now–by quarters to years.

EDITORS NOTE: Electric Vehicles are also part of the other Big Investor Trend — De-Carbonization. Nobody has made more money on this play than ELON MUSK. There is only ONE thing that keeps Elon Musk awake at night, and this company has his kryptonite in spades. Click HERE to get the name, symbol and quick read report!

TOUGH WEEK IN THE MARKETS–BUT HERE IS A “GIMME” TRADE

By
Keith Schaefer
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0

It has been a rough week for global stock markets. But there is still One Big “Gimme” in investing markets. It’s a commodity that will have no cycle for the next 10 years—I expect it to go straight up with almost no volatility.

I’m talking about CARBON.

That’s because CLIMATE is the #1 investing meme for the next 10 years. 

Whether we go to Net Zero or some other worthy goal of reducing carbon, one thing is clear:

The world will be spending TRILLIONS on trying to meet the targe of the world warming only 1.5 degree Celsius by the end of the century.

For sure, climate will be the #1 investing meme through the 2020s.

Carbon pricing will be front and center on that. People will check carbon prices daily like they check gold, copper, oil, (and now bitcoin).

The way I’ve chosen to play this—and there is no perfect way—is through the Kraneshares ETF, symbol KRBN-NYSE.  KRBN is an ETF that follows the price of carbon. I first bought it at $31 and I’m still buying it.

There has been a steady uptrend here with almost no volatility. Can it continue?

Now is an interesting time to revisit this purchase, as this ETF is quite different (unique??) in that it only rolls over its futures contracts once a year, versus once a month for most ETFs that buy futures contracts. 

KRBN “rolled”—or had to change its contract—last month; November. KRBN is unlike oil ETFs which include the cost of physical storage in their roll—so it’s MUCH more efficient. , The roll was about 2% or less. So when the carbon market is this stable, it’s a great product.

I bought KRBN in April at $31.25, and it’s up about 50%.

Source: Stockcharts.com

In the short-term, say this winter, KRBN is going to be driven by EU energy issues. If we get a cold winter – one that requires big-time coal consumption, expect KRBN to move higher yet.

In the long-run, there is only one direction for KRBN to go – up! That is because rising carbon prices are literally baked into the cake. The reality of carbon trading is that prices eventually have to go up.

 

How Does Carbon Trading Work?

 

There are a growing number of regions that have carbon trading schemes. Two of the biggest are the European Union (which has EU Allowances) and California (which has California Carbon Allowances). 

To understand how these allowances work, take EU Allowances (EUA) as an example.

An EUA is an emission allowance that lets the holder emit one ton of carbon dioxide. Companies can trade EUAs if they expect to run a surplus or deficit of carbon emissions for a given year.

The EU issues new EUAs each year in February. There is fairly complicated process used to determine who gets the new EUAs.

Companies buy or sell EUAs via exchanges. The Intercontinental Exchange (ICE) is the most liquid exchange for trading EUAs. The Chicago Mercantile Exchange also lists EUA contracts.

Participants in EUA carbon trading range from electricity utilities, industrial manufacturers to investment banks, hedge funds and even retail investors.

These contracts are all physically settled. The contract transfers the underlying EUA between the counterparties 3 days after the last day of trading for that contract month.

The key feature of these contracts is that every year, the number of EUAs issued goes down. Supply goes down, every year. 

In some cases, there are even mechanisms in place to insure the price does not go down. 

In California they have an auction reserve price that they won’t auction off allowances below. And that auction reserve price goes up 5% plus inflation every year.

In Europe there is the same sort of lever available, called a market stability reserve, which allows them to pull credits out of the market if prices begin to decline too much.

This virtually assures that the price of the EUA will go up. In fact, that is exactly the intent.

 

KRBN – Also Buying Carbon Allowances

 

The KRBN ETF also buys carbon futures. The fund is made up of a combination of European Union Allowances (EUAs) and California Carbon Allowances (CCAs). The weightings track the IHS Markit Global Carbon Index.

 

Source: KraneShares.com

This move (KRBN is up 44% in the last 6 months and has roughly doubled in the last year) is right inline with the move we have seen in the Carbon Index:

 

Source: IHS.com

It has been such a strong move up that it has me asking – can it last?

To answer that, I’ve dug into the factors that are driving the move.

 

Fundamentals

 

KRBN is largely made up of European Union credits. It is EU policy changes that impact it the most.

In July, the European Union unveiled its “Fit for 55” package.

While this sounds like a new exercise craze, it’s not. It is a new set of targets focused on renewable energy, emissions trading, and a foreign levy on carbon intensive imports.

The package aims to bring emissions down to 55% below 1990 levels by 2030.

This will be accomplished by tightening the EU cap-and-trade rules. Europe’s market stability reserve, the mechanism they use to “manage” prices higher, will be buying 24% of credits at auction. As well the floor on prices will be increasing by 4% a year, up from 2%. 

EU carbon prices, which had begun to level off in the spring, made another leg higher after the launch of the program:

Source: FT.com

More stringent carbon emissions and more industries that have to comply mean higher carbon prices. 

That is why the single greatest determiner of price here is whether carbon mandates will accelerate or slow down.

Acceleration is happening in Europe and that is not the only region.

The second regional focus of KRBN is California.

California’s carbon goals are ambitious to say the least. 

Source: BofA Global Markets

While California’s emissions have been roughly flat over the past 30 years, their targets are anything but. 

If California is going to achieve these dramatic emission reductions it just has to mean higher carbon prices.

 

Analysts Increasing Numbers

 

When we wrote about carbon prices earlier this year, we used forecasts like $100 per tonne or $150 per tonne by 2030 to 2035.

Those numbers are coming from governments – the EU, California and Canada for example.

But these are only estimates. We wondered – what if carbon prices need to be higher to achieve the climate goals.

Turns out we aren’t the only ones wondering about this. 

BofA Global Research recently put out a report titled “A Transwarming World Net Zero Primer” where they asked this question.

Their report identified 4 possible scenarios for net zero.

Source: BofA Global Research

The status quo and even the accelerated scenarios are not interesting to me. It simply isn’t going to happen. 

The world has gone too far down the road of carbon mitigation to backtrack now.

What about the aggressive and net zero scenarios? They could mean higher carbon prices than we think.

In the aggressive and net zero scenarios, BofA Global Research estimates a global carbon price of $100/t and $200/t will be needed, respectively.

The key word here is global. A number of lower income countries are simply not going to pay that.

That means carbon prices in the developed world are likely to be multiples of those in the developing world. 

Source: BofA Global Research

Expect far higher carbon prices – as high as $450/t – in regions like the United States and Europe.

Goldman Sachs approaches the problem from a different angle. What is the “average abatement cost”?

By that, they mean for each of the sources of carbon emissions, how much will it cost to remove those emissions?

Some sources, like electricity, are relatively straightforward. Switch away from coal. Others, like shipping, aviation and some types of construction, are much higher.

 

Source: Goldman Sachs Carbonomics

To squeeze those last giga-tonnes of carbon out of the atmosphere could come at a steep price.

BofA research also points to price spikes as carbon reduction approaches its limits.

Also, remember that carbon allowance prices should be inversely linked to actual tons of CO2 emitted. In a corner solution, annual emissions prices could thus skyrocket past $10,000/t, particularly if carbon capture capabilities prove limited, as the global economy approaches net zero emissions into 2045 (Exhibit 101).

Now before you get too excited, remember that’s a long way off – they are talking 20 years before this kind of scenario plays out.

But it goes to show just how unknown this market is.

 

A Big Influx into ETFs

 

But maybe the most interesting driver of carbon prices has simply been the interest in carbon prices.

KRBN hit the IPO trail in 2020 with a splash. It has only grown in popularity since that time.

John Kerry was one of the original backers.

At the time of the IPO Kerry held “a small stake in the firm”. At the time he was an advisor to Climate Finance Partners – which themselves advises on the fund and holds a position in KRBN.

Kerry may still own a position in KRBN. While he resigned from his position as chairman of the advisory board at Climate Finance Partners when he was appointed Secretary of State by the Biden administration, there is no sign he sold his interest in the firm. 

The KraneShares fund is worth over $1 billion right now. That NAV is heavily weighted to EUA carbon futures.

That is still small compared to the carbon market. The EU carbon market is close to $250 billion while the California market is ~$25 billion.

 

Source: BofA Global Markets

But in terms of flows, KRBN and its sister fund, GRN, are growing fast. KRBN saw 32% month-over-month increase in AUM (Assets Under Management). As of October 22nd net AUM had increased to $1.02 billion – another $300 million over August.

Source: National Bank

AUM will almost certainly continue to expand. It is going to be helped by two new issues.

KraneShares is launching two new products. These are separate European and California Carbon ETFs:

KEUA and KCCA.

The KraneShares European Carbon Allowance ETF (KEUA) and KraneShares California Carbon Allowance ETF (KCCA) have been listed on NYSE.

So now you have TWO MORE ETFs buying the same futures. In a very bullish market for carbon prices (NOBODY sees carbon prices declining; climate is the #1 investing meme for this decade) this is like an endless bid.

While I question the attraction of owning Union Allowances (EUA) or California Carbon Allowances (CCA) versus a fund that owns both, I do know that these are just more dollars that will be stuffed into carbon futures.

The bottom line is that the move in the ETFs is not the result of rampant speculation. The market value of KRBN is less 2% above the NAV. 

This is the sort of ETF I would think could trade at a significant premium to NAV.

One way to look at it is that given the virtual certainty that carbon prices will rise over the long run, you are getting a ~8% return on KRBN on the assumption we get to $125/t carbon by 2030.

While that is no barn burner return, it seems fair given a relatively low risk.

The only volatility I see in KBRN is that I have noticed it appears to move down when the market does–to the point where if we saw a BIG pullback in the S&P 500, how would it perform–despite the underlying strength of carbon pricing.

To me, KRBN still looks like a good long-term bet–it acts relatively efficiently, and it is one of the most obvious ways to play the #1 Market Meme of the decade.

EDITORS NOTE–get ready for my new #1 Market Meme stock–a “triple threat” to help reduce carbon emissions globally–including taking direct aim at one of the world’s largest polluting industries. It trades under $1, and I think has the team and the plan to make it a multi-bagger in the coming years. Click Here

THE NATGAS VS. OIL TRADE LONG UNG-NYSE / SHORT USO-NYSE

By
Keith Schaefer
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0

On Monday this week I gave subscribers a trade idea for the winter–be long the US Natural Gas Fund ETF, symbol UNG-NYSE (closing $16.79 that day), and short the US Oil Fund, symbol USO (closing $56.07 that day).

Now don’t get incredulous that this trade idea is a straight up short oil. It’s just a bet that natgas does better than oil–especially until the middle of January, but quite possibly through the winter.

The reason I pick mid-January is because of COVID. I subscribe to a research service that has been uncannily accurate in giving pivot dates for the peak of the COVID waves–and the next one (says my guru) is mid-January.

This week, the trade has worked out. UNG-NYSE is down only pennies, but USO-NYSE is down $2.29/unit. And the reason oil fell this week: Europe starting to shut down again in several places due to COVID. I’ll explain it all in a bit more detail below, but the other side of the trade–long natgas–is a bit more fundamentally driven.

Only months ago, I never thought I would say this: The market is too bearish on natural gas.

Let that sink in for a minute…

I know what you are saying: Wait – how can that be? Natural gas prices are just under $5+ right now. Prices are higher than they have been in years.

How can this be bearish?

Well the focus is all on the front month contract. That is not the whole story.

Looking further out the curve, you can see the pessimism. It is called backwardation.

Backwardation means that the future price of each month out is less than the previous one.

Source: CME Group

The backwardation in natural gas right now is steep. While the prompt month (Dec 2021) is trading at $5.06, May 2022 is actually below $4.

The market is saying “sure, you might get your cold winter but it will end and prices are coming back down”.

It is that sort of pessimism that could give us a 20% on the United States Natural Gas Fund (UNG – NYSE) if gas even just stays at this level and the curve rolls out.

But I have one worry with this trade. The economy.

To hedge that bet, I am suggesting a pair trade – long UNG and short the United States Oil Fund (USO – NYSE).  This is not a bet against oil–just that natgas does better than oil.

 

It Will Be A Tight Winter for Natgas

 

We are almost guaranteed a tight natural gas market this winter. It is going to be tight everywhere.

Unlike past tightness, this is not a North American phenomenon. We have a global shortage of natural gas.

That means two things.

  1. Gas is going to continue to be pulled out of the US market
  2. Speculation is going to remain high

These two factors are going to keep natural gas prices up. That alone, along with a normal winter, and the long UNG trade does well.

But the real upside comes from a cold weather spike. There is a real chance that we get a $10+/mcf handle on natural gas if there’s a prolonged cold snap.

Europe has already paved the way for speculators to drive up natural gas prices if the weather gets cold.

RIDING THE CURVE

Buying UNG, the natgas futures curve is working in our favor. UNG is a very simple product. Here is what the ETF owns:

Source: www.uscfinvestments.com

UNG holds the prompt month natural gas future contract. Every month UNG rolls over that contract for the next month.

In contango, where the futures prices are higher than spot, this roll works against you. But with this kind of huge backwardation, the roll actually benefits UNG holders.

Every month the UNG fund managers are selling higher priced prompt month contracts and buying lower priced out-month contracts. It effectively is buying more natural gas each month.

Of course, by itself that does not make UNG a winner. If natural gas prices fall across the curve, you lose. But it does trim your losses on the way down.

The big win for UNG longs is twofold.

First, if the future curve is wrong, i.e. it is UNDER-estimating an early spring cold snap (think of the two Polar Vortex’s we had in a row a few years back–they were both late winter/early spring). 

I estimate that if the April and May natural gas move up to the $5+ level (from the sub-$4 level they are suggesting now), that could cause a LARGE price spike in the ETF price for UNG.

Second, a big spike over the winter due to cold weather.

 

What Could Go Wrong??

 

I have one big worry about this trade.

You guessed weather didn’t you? Admit it. This is natural gas – the worry has to be weather.

No, not weather.

My biggest worry with this trade is the economy.

I know I’m going to get some pushback here. The stock market is within spitting distance of all-time highs.

How can the economy be anything but strong?

Yet the reality on the ground is telling a different story.

First, while equity markets soar, debt markets are telling us there is something wrong.

The yield curve is starting to flatten.  The two-year yield has increased to 50 basis points from a little over 20 in the last few weeks while the 10-year yield has come down a few basis points.

The bond market is always smarter than the equity market. But you don’t just have to listen to the yield curve – the data is saying the same thing.

One of our favorite indicators is the GDP output gap.

Right now, the output gap is in overdrive. We are producing more goods and services than we should given the level of labor and materials available.

Source: Unit Economics

Typically, this sort of overheat is followed by a period of stagnation.

That is exactly what the Fed seems to be predicting. Three months ago, the Atlanta Fed—the most accurate branch of the Fed in all the USA—was predicting 3% growth in Q3. Then it dropped to 1.5%. Now it is 0.5%.

Source: Unit Economics

This does not make me a bear on the stock market. The factors driving many parts of the market right now are simply not that sensitive to an economic slowdown.

But it does give me pause on a long natural gas trade, because natural gas does move with the economy.

Which brings me to the short side of the trade – oil.

The oil short is simple. If economic activity slows, oil demand slows. With oil prices already printing above $80, there is plenty of downside in that scenario.

Crude oil always reacts more negatively to an economic slowdown than natural gas. That would be doubly the case this year if it is accompanied by cold weather.

Meanwhile the upside on oil if the economic slowdown thesis doesn’t play out is far more limited than natural gas.

 

Don’t Hold Your Breath On Supply

 

The other thing that you always have to worry about with natural gas is supply. But for the moment I think you can put those concerns aside.

There are just too many dis-incentivizes to increasing production right now.

First, back to the futures curve.

That backwardation is not encouraging more production. While front month economics look stellar, prices swoon out even a few months. If you bring on a new well now, you are doing it at $4 expectation, not $5.

As a producer you’ve been hit with years of disappointment. The price always comes down. The curve is just backing up what you already know.

There are other headwinds. Producers need to look environmentally friendly. They need to appease shareholders that are demanding a return of their cash.

In this kind of environment, you need a curve with a whole lot of optimism – not pessimism – to entice more drilling.

 

A Simple Bet

 

This is a pretty simple trade. I think natural gas has more upside and less downside than oil over the next 4-6 months.

I’m not saying that higher natural gas prices are a sure thing. That is exactly why I am not just going long UNG and calling it a day.

We have a front month gas contract that is a tad under $5. At that level, things could go wrong. But the most likely thing to go wrong – the economy – would go even more wrong for oil.

It’s a paired trade.

Ideally the best of all worlds is the next six months where natgas prices move up, and oil prices go down. But even a nice little move up of that natgas futures curve–as we step through winter– will hopefully create a spike to sell into. 

But if we do have an economic downturn or a COVID resurgence, the USO short really gives this trade some juice.

THE FIRST NEW NORTH AMERICAN OIL PLAY IN A DECADE THE CLEARWATER

By
Keith Schaefer
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0

Keeping up with oil and gas companies 10 years ago was not easy. The dynamic duo technologies of fracking and horizontal drilling were opening up MANY new shale plays all over the continent. There was a huge land race, with companies buying each other up to get as many potential drilling locations as possible.

Now, not so much. Everyone has lots of land & drilling inventory. And up until a year ago, a lacklustre oil price kept investors away (ignoring the continued huge increases in efficiency–getting more oil out with lower costs).

There have been no new BIG onshore oil discoveries in North America for a long time–and who would have cared until recently?

But there is a new kid on the block in the Western Canadian Sedimentary Basin – the Clearwater heavy oil play.

The Clearwater started to make waves in 2019 as production grew from 5,000 bbl/d to over 15,000 bbl/d. 

While the pandemic burner for a time, rising oil prices and a few new players in the area this year have brought the attention back.

The reason for all the attention is simple – these are the single best economics of any new play in NA in a decade.

The chart below comes from Tamarack Valley (TVE – TSX).  It compares their Clearwater economics to other plays across North America at $60 WTI.

Source: Tamarack Valley Investor Presentation

Believe it or not but Tamarack is not even in the Tier-1 acreage of the of the play.

Headwater Exploration (HWX – TSX) is in the core of the play.  They have a land package in the area of the Marten Hills.  They purchased the land from Cenovus Energy (CVE – TSX) last year.


Source: Headwater Exploration Investor Presentation

Headwater’s results have been impressive.  They released Q3 results this week, saying that they had “grown oil production from 3,385 bbls/d in the first quarter of 2021 to current levels exceeding 9,000 bbls/d.”
 
Headwater estimates a payout of 4 months at $55 WTI.


Source: Headwater Exploration Investor Presentation
 
The results continue to improve. Headwater says that the results of their last 11 wells have had IP30 rates of 400 bbl/d, which is 33% above the 300 bbl/d rates of older wells.

 

WHAT HAS MADE THE CLEARWATER SUCH A GOOD PLAY
 

You would think these must be light oil gushers to produce these kind of economics.

Well, you’d be wrong.  What drives the Clearwater is technology and cost.

The technology is drilling – very tightly spaced multilateral wellbores. 

Companies are drilling 8-leg multilateral wells at 4 wells per section – 32 legs in all.


Source: Headwater Exploration Investor Presentation

Declining drilling and advances in drilling technology mean that they can drill these wells quickly and extremely accurately.

These are mile long laterals a couple hundred feet apart.  The tight spacing of the laterals removes any need to frac.  The wells require no casing in the lateral at all – another savings – and are completed open-hole.

It is bare bones and cheap, cheap, cheap.

Headwater estimates $1.35 million per well at Marten Hills.   Tamarack’s capital costs at Nipisi are $1.1 million per well.

Low costs, low water-cuts, shallow decline curves and plentiful infrastructure add up to very economic wells even if they aren’t gushers.

The best wells in the Tier 1 area are coming onstream with an IP30 of ~600 bbl/d.  It’s a good rate, but remember it is coming from 8 laterals.


Source: Headwater Exploration August Investor Presentation
 

THE PLAYERS–PRIVATE COMPANIES
DOMINATE THE ACREAGE

 
Getting my head around the Clearwater has not been an easy task.  The area is dominated by private companies which means data is scarce (private cos. rarely have corporate presentations or give public updates).

Baytex Energy (BTE – TSX), Tamarack Valley and Headwater are the main publicly traded stocks to play. 

A fourth play, Rubellite Energy (RBY – TSXv) recently was spun-out of Clearwater assets from Perpetual Energy (PMT – TSX).

But much of the land in that core Marten Hills area is private.   Spur Petroleum is the biggest landowner.  All the flat green colored land in the map below belongs to Spur.

Source: Stifel

The #2 and #3 land holders are also private – Rolling Hills (300 sections) and Crestwynd (290 sections).  Deltastream, another private company, is right up there twith 190 sections, with much of that in the middle of Tier 1 Marten Hills.
 

JUST HOW BIG IS IT?

 
Marten Hills is the Tier 1 core area.  In 2019, when the play was in its early stages nearly all the wells were in Marten Hills.  Since then some operators have ventured further out.  Tamarack has drilled out a few sections at Nipisi.  There is a smattering of wells elsewhere.

This is not a homogenous play.  While the economics look good across the play, the geology at Marten Hills is different than elsewhere.
Source: National Bank of Canada

Marten Hills oil is 22°API while it is mid-teens elsewhere (the lower the API, the thicker/more gooey the oil is). It also has the thickest net pay by some margin.

Headwater gave a good slide in their corporate presentation that illustrated how net pay changes across the play.

Source: Headwater April Investor Presentation

Nipisi, which is east of Marten Hills, has been the second most active area, thanks largely to Tamarack.. 

Tamarack owns land in both the Nipisi and Jarvie area.
 


Source: Tamarack Valley September Investor Presentation

Tamarack’s Nipisi results look good so far.  Their main development area is ~6 sections and has average IP of 185 bbl/d.

185 bbl/d is quite a bit less than the Marten Hills numbers of 400-600 bbl/d.  But according to Tamarack, these wells are paying out in 7-8 months, which is solid.

Source: Tamarack Valley September Investor Presentation

Jarvie, to the south, is too early to call.  Wells drilled so far are showing ~150 bbl/d IPs.

Jarvie is a very different beast than the Clearwater to the north.  Net pay is 5-8m, much thinner than both Marten Hills and Nipisi.  Reservoir pressure is more than 3x higher.  That makes it hard to extrapolate what we see from the north.

Tamarack bought their Jarvie position from Spur.  You could look at this both ways – Tamarack’s interest in the area vs. Spur’s decision to divest it.

Even at Marten Hills results vary a lot.  Below is a snapshot from Headwater’s April presentation.  In yellow are the Headwater operated sections (in yellow) that are outside of the core development area:


Source: Headwater Exploration Investor Presentation

Headwater drilled the above listed 6 exploration wells across these sections.  The results were…. okay.  Three wells had 4 laterals (instead of 8) and we don’t know how these wells were operated, but the IP30 and current rate data is less than stellar.

The stock has stalled out since May.  That might not be coincidence.
 

CLEARWATER TO THE NORTH….I THINK
 

 The majority of the Clearwater drilling has centered on Marten Hills and Nipisi.

Baytex however, have begun to drill wells way to the NW.
Or are they? 

I pose it as a question because Baytex describes their “Peace River Clearwater play” as Clearwater “equivalent”.

Baytex is actually targeting the Spirit River formation – which they refer to as analogous to the Clearwater:



Source: Baytex Investor Presentation

Is this Clearwater or isn’t it?   It is in the “Clearwater fairway”.  Maybe that is good enough.



Source: Baytex Corporate Presentation

The truth is the Spirit River formation is about the same depth as the Clearwater, the wells design looks similar, so maybe I am splitting hairs. 

What you can say about the Baytex Clearwater equivalent is that the well results look good.

Their first 3 eight lateral wells flowed IP30s of 695 bbl/d, 412 bbl/d and 930 bbl/d.



Source: Baytex Corporate Presentation

These are Clearwater-like results.

Most important, the IRR on these wells is within the range of the Clearwater wells to the South, which is to say – pretty darn good.

Source: Baytex Corporate Presentation

The results are good enough that Baytex adjusted their spending plays to drill 4 more wells into the Clearwater in Q4.
 
So is it the Clearwater or is it Spirit River?  And does it even matter?

 

The Players

 
The go-to pure-play is Headwater – a $950 million market cap company with $80 million of net cash.

Headwater owns 280 sections of Clearwater land.  They have a core area in Marten Hills where they have had incredible wells.   But much of the surrounding acreage is untested – their core operations comes from just ~8 sections.



Source: Headwater Exploration Investor Presentation

Headwater produced 6,500 boe/d in the second quarter.  They have guided to 9,000 – 9,500 boe/d average production in Q4.

Tamarack Valley owns 160 net sections at Nipisi and another 120 net sections at Jarvie.  At Jarvie this includes the 53 sections they added from Spur at a little over $1,000 per acre.

Production comes entirely from the Nipisi – 5,200 boe/d.  That is 40% of corporate wide production.

Tamarack has outlined 500+ locations on their property at $50 WTI. 

The Clearwater locations make up ~60% of Tamarack’s overall locations.  They expect to spend 40% of their capex budget on growing their Clearwater production.

Baytex has >120 net sections that are prospective for their Clearwater equivalent Spirit River formation – called Peavine.    Peavine is ~200 miles NW of Nipisi.

Baytex budgeted 7 wells into Peavine this year.  Five of those are now on production.  Two of these wells rank at the top peak calendar rates.



Source: Baytex September Corporate Presentation

Baytex is expecting an expanded program in 2022 with 12-18 wells drilled.

A more risky micro-cap bet would be Rubellite.  Rubellite is a spin-out of Perpetual.  The market cap is still in flux because of soon-to-expire warrants but it’s ballpark $70 million depending on their exercise.

Rubellite owns ~100 sections of prospective Clearwater land.  They are forecasting 650-700 bbl/d of production in Q4, and forecasting over 2,000 bbl/d by the end of Q1 2022.

Rubellite has land throughout the play. 


Source: Rubellite Energy Investor Presentation

Their crown jewel is a very small (1.5 net section) position smack-dab in the core of Marten Hills (with 1 well on production and 2 more locations).  They have a larger position west of that core area that appears untested. 

Rubellite also own land to the south, around Jarvie, and land just north of Baytex’s Peavine.

There are a few wells on production at the southern land (Figure Lake and Ukalta).  Rubellite is estimating paybacks of 0.7-0.8 years based on type curves so far.

Finally, Cardinal Energy (CJ – TSX) has a small 3 section position in the Nipisi Clearwater.  They are planning 4 wells in Dec-Jan.
 

WHAT TO WATCH FOR

 

We know that the Clearwater at Marten Hills is first-in-class.

What we don’t know is how all the surrounding area will perform.

Over the winter we are going to see well results at Jarvie, Peavine and some exploration wells in the other surrounding untapped acres.

It is still early days and all of these areas.  We have some big land positions for the public players so positive well results – especially if they look like Marten Hills – could drive these names much higher.

But the Clearwater is no longer a hidden gem.  It is on everyone’s radar.
 

I will be watching those results closely. The latest quarterlies all showed good to great results out of the Clearwater. The next move up for these stocks will be continued drill results and their next quarterly.

Keith Schaefer

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