In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. If you want to know what a TFSA is, I recommend you read my free book.
August Results: Down 3.8%
At the end of August, I had $57,314 in my TFSA account, which was down by 3.8% since the start of the month. By comparison, the Canadian stock market went down by 0.8% while the U.S. stock market went up by 3.0% in Canadian dollar terms. Therefore, my portfolio underperformed the broader market.
The majority of my portfolio consists of oil and gas stocks. Oil prices remained flat in August, going from $69.88/bbl to $69.84/bbl (in US dollars). However, my stocks were affected by the Canadian court’s decision to quash the trans mountain pipeline expansion.
Pipeline projects such as the trans mountain expansion are important because there’s currently not enough pipeline capacity to transport all the oil produced out of the oil sands. Oil companies have been transporting the excess oil using rail, but that is a costlier solution. Without the cheaper means to transport the oil, investors fear that oil companies will have a harder time turning a profit.
However, pipelines are not the be all and end all for oil companies. Even if oil prices stay at current levels, my oil companies should turn solid profits. For example, I think that MEG Energy, whose shares I own, should be able to earn something in the region of hundreds of millions next year if oil stays near $70/bbl, regardless of whether the expanded pipeline exists or not.
But if that’s the case, why are oil stocks still doing so poorly so far this year? The question puzzled me for some time, but I think I now understand after reading some of the oil companies’ latest financial statements.
Let’s examine MEG’s financial statements as a case in point. During the three months ending June 30 this year, MEG recorded revenues of $674 million, but lost some $223 million before accounting for taxes. This sounds alarming initially, but it’s not a big deal if you look at the details. MEG’s list of expenses included a $150 million charge for loss due to “commodity risk management”, as well as a $64 million charge for loss to due “foreign exchange”. Let me explain what these items are.
In order to protect against potential oil price crashes, oil companies enter into contracts that fix the future price of oil. For example, MEG currently has a contract that fixes 29,000 bbls/d worth of oil at $54.16 USD for the second half of this year. If oil prices end up going below this number, MEG receives money from its counterparty. But if oil prices end up going above this number, MEG has to pay.
As you probably know, oil prices have been rising steadily over the past year. The amount that MEG would have to pay its counterparty has therefore increased, and this increase is reflected on MEG’s financial statements as losses due to commodity risk management. While such losses are “real” (in the sense that they affect a company’s intrinsic value), they are temporary. MEG will not record further losses unless oil prices continue to go up, and most of these contracts will expire over the next year.
Foreign exchange losses are similarly temporary. MEG incurs such losses because some of its debt is denominated in US dollars. When the Canadian dollar weakens, the amount that the company owes in terms of Canadian dollars goes up and the financial statements reflect that loss. Unless the Canadian dollar keeps weakening forever, foreign exchange losses will stop at some point.
Without these two items, MEG would have just about broken even during the April to June period of this year, and this is even with the high price differential between US and Canadian oil prices seen due to pipeline constraints.
With the trans mountain pipeline issue settled for the time being, oil producers have begun to sign deals with rail companies to transport oil to the US. The cost to transport oil by rail is about $10-12/bbl, which is substantially below the current US/Canadian price differential of about $30. If the price differential stays at $30, Canadian oil companies will simply ship the oil by rail and receive the US oil price. The US/Canadian price differential should therefore narrow in the coming years, and MEG should be able to turn solid profits if US oil prices stay where they are.
I’m not the only person who understands this, of course. Some savvy investors have been “pounding the table” that this is the right time to buy oil stocks. But the problem is that their messages are falling on deaf ears. This, after all, is a market where in-vogue stocks like Tilray (a marijuana stock) and NIO (electric car company) are notching massive gains. Even somewhat sophisticated investors using quantitative strategies are shying away from oil stocks because their accounting earnings are negative. Quantitative strategies generally don’t utilize more than skin deep analysis on each company.
On the other hand, investors who undertake deep analysis of companies are becoming few and far between. These investors generally run value oriented hedge funds and mutual funds. Unfortunately, many value investors have had terrible runs of late, and have had their funds either shrink in size or shut down altogether.
Given that we are left with generally less sophisticated market participants, I believe it will take some time for my oil stocks to do well. Oil company profits will have to be blindingly obvious before quantitative strategies prompt investors to buy the stock. My best guess is that this won’t happen until sometime next year.
But when the market does realize the true economics of my oil stocks, I’m confident that their prices will increase quite rapidly. As a patient investor, I will stick this one out.