Big Declines Are Bullish

Bear markets begin with a whimper, not a bang. That’s food for thought in the wake of Canadian trusts’ dramatic decline over the past two weeks.

In the June 2008 Canadian Edge Portfolio article, The Case against Oil and Gas, I highlighted the growing likelihood of a near-term pullback in energy prices and advised investors to take some of our profits in surging oil and gas producer trusts. My reasons were the likelihood of at least a temporary reversal of this year’s parabolic rise in energy prices and many investors’ growing certitude that they couldn’t lose money by investing in trusts.

As it’s turned out, oil and natural gas prices have backed off sharply from recent peaks. Energy stocks, meanwhile, have suffered a full-scale rout. And although most trusts have bounced back sharply from the intraday lows hit Tuesday, many are still 15 to 20 percent off where they were only a couple weeks ago.

Extreme volatility is the rule, not the exception, in a volatile market such as energy. Recession-fearing investors, however, have also hit trusts that have nothing to do with oil and gas production, adding to the disappointing returns many of these have suffered all year.

The result is a major gut check for our trust positions across the board. The market is telling us something here. The question is what.

Is this the end of the road for energy and Canadian trusts in general, either because of an unfolding global recession or some other reason? Is the Canadian economy coming apart at the seams as the US seems to be? Or is this merely a long-overdue correction in a market that had become far too overheated this year, with a carryover to all things Canada?

Still Bull

Only time will provide the answers. But despite the palpable fear level in this market and accompanying volatility of recent weeks, this still looks like a correction within a historic bull market. In fact, the market’s rapid mood swing actually reinforces the bullish case.

Big declines in markets are bullish for one major reason: They’re the fastest way possible to eliminate the hype and froth that caused the overheating in the first place. Nothing banishes the myth of a “can’t-lose” market like a steep, sudden correction.

To borrow another oft-used cliche, bull markets climb a wall of worry. And in the past two weeks, complacency has been wrung out of the energy market, replaced by high anxiety.

Big declines are also bullish because they reset valuations back to more-favorable levels. As indicated in the July Canadian Edge issue, the number of oil and gas producer trusts trading below buy targets was rapidly shrinking a couple weeks ago, as share prices rose without commensurate distribution increases. That’s no longer the case after this correction. In fact, ARC Energy Trust (TSX: AET.UN, OTC: AETUF) is back trading at roughly the same level it was before the last two months’ combined 40 percent distribution increase.

The only thing that would turn this correction into the beginning of a full-scale energy bear market would be an undermining of the bull market’s basic underpinnings. That’s enough conservation, use of alternatives and new discoveries of conventional energy supplies to tilt the balance of market power back to consumer nations from the producers. And although we’ve made progress on all fronts, we’re no where close to such a quantum shift.

To be sure, recessions can take a toll on energy prices for a while. This one would have to reach Asia to have a major impact, and there’s no evidence anything of the sort is taking hold. Even in such a case, however, the impact would be temporary. In fact, lower prices caused by a recession would encourage demand, discourage conservation and alternatives, and probably limit development as well.

As a result, a recession-spurred energy price correction would actually strengthen the forces behind the bull market. Once the economy revived—and falling energy prices would definitely help it along—bull market conditions would be back in force again, and prices would no doubt move on to higher highs.

A recession-led drop in energy prices would, of course, take a near-term bite out of industry cash flows. But here, too, trusts are well protected by virtue of the systematic hedging they employ.

In the first quarter of 2008, most oil and gas trusts sold oil well under $80 a barrel and natural gas for less than $8 per million British thermal units (MMBtu). That’s more than a third below spot prices for both fuels.

The reason for the lower realized prices is low-priced hedge positions that are coming off month by month. As they do, they’re replaced by higher-priced hedges, locking in a steadily rising cash flows the rest of the year even if oil and gas prices fall dramatically from here. Second quarter results are expected to be particularly robust.

That means a lot more cash for boosting distributions, which were covered in the first quarter at realized prices well below current spot prices. It also means dramatic debt reduction and higher production—in other words, more valuable companies.

How far would prices have to fall to negatively affect trust distributions? The best clue is the fact that trust payout ratios averaged 50 to 70 percent in the first quarter, selling oil at less than $80 a barrel and gas at less than $8 per MMBtu. Basically, oil and gas will have to fall at least that far to impact cash flows negatively and a lot further to threaten dividends. Last year, for example, trusts covered distributions handily, selling oil at less than $60 a barrel.

What to Do Now

The bottom line is this: This isn’t the end of the energy bull market, and Canadian oil and gas trusts are extraordinarily well positioned to deal with a continuation of the near-term downtrend in energy prices.

The time to take profits off the table is over for now. But there should be plenty more opportunities to make this kind of move on the way up in coming years. The rapid decline in share prices may or may not be over. But the values are stark.

It’s a good time to buy shares of first-rate oil and gas trusts but with one major caveat: Be prepared for more possible downside. This is a fear-driven market, and a lot of people are simply panicking. That’s a formula for more down days, and as we’ve seen clearly recently, even the safest distribution yield isn’t foolproof insurance against selling.

In fact, many people seem to have adopted a “someone knows more than I do” approach on down days. And their selling only depresses prices more, which, in turn, begets more selling for no fundamental reason.

Eventually, strong businesses prevail over marketplace panic. But it can take time, and only those willing to follow the business numbers—which includes selling if they deteriorate—should invest dollar one.

That’s also the key for the other trust sectors. As I pointed out in the July CE, the issue here is how well businesses are standing up to rising fuel prices, credit challenges and the rising Canadian dollar. Those that stand up to them will hold and even increase distributions going forward. Those that don’t won’t be able to.

Over the past two weeks, the market really hasn’t made much distinction between stronger and weaker trusts in the power, energy infrastructure, real estate and other sectors. Rather, we saw mass selling of virtually everything, presumably on worries about the Canadian economy.

Ironically, as CE Associate Editor David Dittman points out in this week’s Maple Leaf Memo—as well as in the July Canadian Currents—the Canadian economy remains solid. Growth is expected to swing positive in the second quarter, a major plus considering Canada is running at nearly full employment. Meanwhile, the country’s central bank has apparently decided Canada’s major banks no longer need assistance, as credit conditions relax.

Energy prices will obviously play a major role in how fast Canada grows. And the weakness of the US economy will continue to hurt some businesses. I noted in the Portfolio article of CE that GMP Capital Trust (TSX: GMP.UN, OTC: GMCPF) and TransForce (TSX: TFI, OTC: TFIFF) were my primary concerns at the moment, and they remain so as we await second quarter earnings results.

I’m at least equally convinced, however, that the selling we’ve seen in the electric power sector—which has been, in some cases, worse than the energy trusts—is completely divorced from the reality of their underlying business strength. The good news is second quarter earnings should calm at least some of the fears that seem to be percolating in the marketplace.

The bad news is we’re going to have to wait a few weeks for the releases. Atlantic Power Corp (TSX: ATP.UN, OTC: ATPWF) won’t announce until Aug. 13. The company’s principals have been more than willing to spend time on the phone with investors. But apparently only new numbers are going to really answer the market’s questions. Even an analyst upgrade last week failed to make much difference.

If there’s one thing I hate in this business, it’s seeing people lose money, and the feeling gets a lot worse when it’s happening in my recommendations. I’m as convinced as ever, however, that the winning approach here is to focus on business health, not rumor, innuendo or conspiracy theories about what’s affecting share prices near term.

We’ve taken a hit to our holdings across the board here, and it’s possible we could see more selling. Canada has huge advantages over other nations in mid-2008, but it’s not an island from global turmoil.

However, unlike the last real sudden across-the-board shellacking trusts took—in the wake of the Halloween taxation announcement—the catalyst for this has little to do with Canada or the health of the trusts themselves. And that’s a great cause for comfort when it comes to evaluating what we want to buy, hold or sell in one of the toughest markets in memory for income investors.