Industry Overview: Oil and Gas By Michael Southern

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1 Oct 11, 2016 Volume 22 Issue 10 Page 1: Industry Overview: Oil and Gas Page 3: ETF Spotlight: ZUT & ZWU Page 6: Canadian MoneySaver Portfolio Update Page 8: Question and Answer With the energy sector accounting for almost 20% of the S&P/TSX, second only to the financial sector and 13.4% of Canadian GDP (2013), energy companies in Canada are without a doubt some of the most important contributors to our country s economic success. When you fill your car with gasoline, you are the final link in a long chain known as the petroleum, or oil and gas (O&G), industry. In Canada, the O&G industry is often associated with the Oil Patch. The industry is one of many in the energy sector; however, it is here where we will focus this article, as companies here are likely most important to Canadian investors. Statistics Canada has the third largest oil reserves in the world. It is the fifth largest oil producer and fourth largest exporter. In 2015 Canada produced an average of 621,610 cubic metres per day (3.9 Mbbl/d) of crude oil and equivalent. Of that amount, 61% was from oil sands, or the Oil Patch. Most of Canadian petroleum production is exported, approximately 482,525 cubic metres Industry Overview: Oil and Gas By Michael Southern Market Radar In This Issue: Markets TSX Composite S&P 500 P/E Yield (%) YTD Performance (%) Top Performers ETF Mutual Fund 1-Month Canadian Crude Oil ETF Crystal Enlightened Res and Met. YTD BMO Junior Gold AlphaNorth Resources 3-Year BMO Low-Vol US Equity Dynamic Precious Metals Market data as of October 5, 2016; top performers as of month-end. Note: We are no longer including leveraged ETFs in top performers list per day (3 Mbbl/d) in 2015, with almost all of the exports going to the United States. Canada is by far the largest single source of oil imports to the United States, providing 43% of United States crude oil imports in In 2015, Alberta produced 79.2% of Canada s oil, Saskatchewan 13.5%, and Newfoundland and Labrador produced 4.4%. Structure The industry can be broken down into three segments: upstream, midstream and downstream. The upstream industry finds and produces crude oil and natural gas. The upstream segment is sometimes known as the exploration and production (E&P) sector. The midstream industry transports (by pipeline, rail, barge, or truck), stores and wholesale markets crude oil, natural gas, natural gas liquids and others. The last is downstream, which is the refining of crude and the distribution of its by-products. The downstream industry touches wherever consumers are located and provides thousands of products such as gasoline, diesel, heating oil, propane, asphalt, lubricants, synthetic rubber, plastics, etc. OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on Page 2 1

2 Pricing The global marketplace sets oil prices via the supply/demand balance. Internationally traded, oil can move from one market to another by ship, pipeline, or barge. Prices vary to reflect the cost of transporting crude oil to that market and the quality differences between the various types of oil i.e. heavy vs. light crude oil. Media most often quotes the futures market price in the nearest month as representative of the current price of oil. Understanding how a barrel of oil is priced can be confusing, as multiple prices are quoted in the market. The most important is the pricing on a barrel of West Texas Intermediate, or WTI. WTI is used as a benchmark price for North American Crudes and underlies oil futures contracts on the NYMEX. WTI is a reference price for light crude oil delivered at Cushing, Oklahoma (a major pipeline hub). WTI peaked on July 11, 2008 at US$147 per barrel. Brent oil prices are also an important price point for many other crude oils around the world. In Canada, prices are commonly quoted on a barrel of Western Canadian Select, which is a reference price for heavy crude oil (e.g. blended bitumen) delivered at Hardisty, AB. This oil trades at a discount compared to lighter crudes, as it takes more energy to produce refined products (e.g. gasoline) from heavy crudes. Investment Characteristics Expect earnings volatility as commodity prices can move up or down significantly in a short period of time. Debt is typically a large component of the balance sheet and companies have high leverage ratios. High level of costs associated as non-cash items such as depreciation, depletion and amortization, coupled with a large amount of deferred taxes. A focus on free cash flow, cash flow from operations and core cash flow. High levels of non-cash items are good reasons to use cash flow as the dominant measure for success and not net income. This focus also allows for increased certainty in meeting debt obligations. Drivers of Performance Economic growth: Over the long-term, a growing economy will have the largest impact on oil and gas share prices. An expanding economy leads to more people driving and forming households, industrial output and inflation. All of these lead to greater consumption of oil and gas. When economic growth increases or is anticipated to increase, energy prices often begin to climb higher. Price of oil: O&G production costs are fixed so changes in oil prices flow directly to the bottom line. Therefore, stock prices tend to be highly correlated to oil prices, which often lead to higher volatility. Thus, the ideal time to own stocks in the oil and gas sector occurs when energy prices are rising. Long periods of high prices and profitability typically lead to increased production. This eventually translates into more production, which depresses prices via the supply function. Supply and demand: Energy prices are determined by supply and demand. Energy production (the supply) is tied to credit conditions and the ability to finance capital expenditures. These are more long-term considerations. In the short-term, supply is affected by price with producers decreasing or increasing production based on energy prices and their marginal costs. Another short-term factor that can affect energy prices, and thus share prices in the oil and gas sector, is geopolitical turmoil, which has the potential to reduce supply. OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on Page 3 2

3 Demand is much more variable and can have an effect on a short-term time frame. Changes in demand for energy are ultimately determined by changes in economic growth, as described above. Technology: advancements in the methods by which oil and gas are extracted from the ground can dramatically shift the sector along with balance of power amongst producer nations. A recent example of such a shakeup would be the advancement of fracking. The technology has revolutionized the US energy industry and significantly boosted domestic oil production, driving down gas prices. It is estimated to have offered gas security to the United and Canada for about 100 years. Production and Reserves Although beyond the scope of this article, no discussion on the sector would be complete without commenting on O&G production and reserves, as these metrics are used extensively in valuation. Reserves are the amount of resource still in the ground. Production is the average amount of resource being pulled from the ground. As oil and gas is produced, reserves are depleted. Production creates cash flow that can be used to replace reserves. It is also important to consider how reserves are replaced, either by the drill bit or acquisitions. There are three types of reserves: proved, probable, and possible. Proved reserves have a very good chance of being produced. Probable reserves have a 50% chance of being produced, while possible reserves are the least likely. The production-to-reserves ratio is used to determine if a company is replacing the reserves depleted through production. Operating netback is a measure used in the oil and gas industry to reflect the net profit on oil and gas after royalties, production, and transportation expenses. The netback allows analysts to compare the operations of different oil and gas producers without being distracted by non-operating, financing, or other extraneous costs. It simply shows how efficient the company is at extracting and selling its product. Valuation Canadian investors will no doubt be familiar with the steep decline in energy prices over the past two years and the resulting loss of shareholder value, as companies cut production and capital expenditure (CAPEX) budgets. At the end of September 2014, a barrel of WTI traded for roughly $95. A low of $26 per barrel was reached in February of this year. That is more than a 70% loss in less than two years. Fortunately for investors and O&G companies, 2016 has seen a modest recovery in prices. Today, WTI trades in the range of $50 with recent news of a potential OPEC deal. The pick-up in prices has fueled positive sentiment towards the industry and stocks have rallied. However, this good news has yet to find its way fully into company earnings and cash flow. This has the effect of stretching valuations, as fundamentals have been outpaced by price components. Indeed, looking at the Top five energy sector names by market-capitalization, we can see stretched multiples when evaluating the cap-weighted average. Valuations are shown below. As a comparison, the S&P/TSX trades at a forward price-to-earnings ratio of 19.0, price-to-book ratio of 1.6 and yield of 3.1%. OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on Page 4 3

4 Ticker Market-cap Dividend Weight P/E P/CF P/B ($billion) Yield SU.TO % % ENB.TO % % TRP.TO % % CNQ.TO % % IMO.TO % % Average 100.0% % Source: Thomson Reuters (September 19, 2016) Investment Options ETF Spotlight: BMO Equal Weight Utilities Index ETF & BMO Covered Call Utilities ETF This month s ETF Spotlight is a departure from the normal as we will be covering and comparing two ETFs: BMO Equal Weight Utilities Index ETF (ZUT) and BMO Covered Call Utilities ETF (ZWU). At face value, there would appear to be little differentiation here other than the option income strategy available through ZWU. However, under the hood there are fundamental details the investor should be aware of in a search for sector exposure. By Michael Southern aspx?t=xic&region=can&culture=en-ca measuring-perfomance Name Ticker Country MER AUM 12mnth Focus (%) ($mm) Yield (%) Exchange BMO S&P/TSX Equal Weight Oil & Gas Index ETF ZEO Canada 0.62% % CAD ishares S&P/TSX Capped Energy Index ETF XEG Canada 0.61% % CAD Horizons NYMEX Crude Oil ETF HUC US 0.85% % CAD Energy Select Sector SPDR Fund XLE US 0.14% % US RBC Global Energy RBF462 Global 2.10% % CAD Canoe Energy Income GOC2001 Canada 2.90% % CAD will continue to support the sector, the premium valuation does increase the risk of some higher volatility should valuations pull back, or investors with gains take some profits in the short-term. This risk does not mean investors should take drastic action in their sector allocation. However, for those who are building their allocation or adding significant capital to the sector, averaging in over a longer period may be prudent. Market Valuation and Outlook The utility sector has had an excellent Demanding higher stability and yield in the face of increased volatility and a lower for longer rate environment, investors have bid up the sector. Valuations are appearing stretched in some areas and the sector is trading close to a 5-year high. ZUT/ZWU are each up over 16.9% on the year. Sector names like Enbridge and TransCanada are trading at a forward P/E above 22x and offer yields close to 3.5%. Historically investors would expect closer to 4.5% from the sector portfolio. While yield hungry investors All is Not as it Appears A quick examination of the ETF naming convention would lead an investor to believe both hold utility stocks in the portfolio, while ZWU offers an additional yield stream by writing covered calls and collecting the premium. The latter point is true. However, investors should be aware ZWU has positions that go beyond the traditional definition of an energy utility. ZWU does hold ZUT in its portfolio but only at a 5.5% weight. Sector allocations on ZWU are as OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on Page 5 4

5 follows: utility (42.2%), energy (31.5%) and telecommunications (25.3%). A naming convention that incorporates Infrastructure may make more sense. The energy allocation is mostly comprised of pipeline companies like Enbridge (ENB) and TransCanada Pipelines (TRP). We tend to disagree with this classification (preferring to group such names under utility ) but the important part to note here is that the energy allocation is not to higher risk exploration and production stocks, for example. We think the allocation to telecommunications is an added value for Canadian ETF investors. To our knowledge, there are no ETFs traded in Canada that focus exclusively in the sector. Therefore, for those looking to build an allocation to diversified defensive sectors, ZWU could be a one-stop-shop, as the companies in the portfolio are representative of the broad North American telecommunication sector: Bell Canada Enterprises (BCE), Rogers Communications Class B (RCI.B), Telus (T), AT&T (T:US) and Verizon Communications (VZ:US). Another key difference regarding the allocation would be at a regional perspective. ZUT is entirely Canadian where as ZWU shows a roughly 1/3 allocation to the United States (US) with the remaining to Canada. The allocation to industry leaders in the US (like VZ) leads to an increased allocation to larger capitalizations. As per Morningstar data, the size allocations across ZUT/ZWU, respectively are as follows: giant-cap: (0/25%); large-cap (25%/50%); mid-cap (55%/25%); small-cap (20%/0). As such, ZUT may have a greater exposure to growth drivers as would be expected with a tilt to lower capitalizations. A Focus on Yield One of the cornerstones with an investment in the utility sector is the expectation for a relatively high and stable dividend. Historically, both funds have been successful in this regard; however, an increased demand for yield has bid up prices at a faster pace than companies have been able to increase the payout. This has resulted in yields falling below historical levels. Below we show the yield profile for both ZUT and ZWU: 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% Annualized Dividend Yield Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 ZUT ZWU 6.7% 3.9% Both yields are attractive when one considers the broad market as represented by the S&P/TSX, which currently yields around 3.2%. However, ZUT is offering less than what has been historically available. At a 3.9% yield, ZUT is trading just above a 5-year low. Over the measured period, ZUT has an average annualized yield of 4.8% and ZWU at 6.4%. The current annualized yield of 6.9% for ZWU is actually higher than the historical average. There has also been an increased yield spread of ZWU over ZUT. At its lowest point, this spread was 0.7% in May Today, the spread is 2.8%. Taxable Investors Should Take Note While the majority of distributions from ZUT are eligible Canadian dividends, ZWU often shows a higher percentage of total distribution originating from return of capital (ROC). For example, in 2015 distributions totaled $0.94 per share. Of this amount, $0.46 was from eligible dividends and $0.41 from ROC. The percentage composition varies year-to-year but investors should be aware of the tax consequences here as ROC has the effect of OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on Page 6 5

6 lowering the adjusted cost base. ROC is not a bad thing, as long as it is sustainable, but is common with covered call funds or any fund that attempts to maintain a level payout. BMO ETFs treat the premiums earned from writing call options on portfolio securities as capital gains. While the premiums earned are paid out as part of the monthly cash distributions, the premiums are combined with the gains and losses from selling underlying holdings which may result in higher ROC on the T3 tax form. In the money options do not decrease the value of the ETF, as the increase in value of the sold option is offset by the increase in value of the underlying portfolio holding at the same time. As the invested capital is not depleted, this would be good ROC. How Has it Performed? Even with all the differences to consider, we would still expect to see similar performance given a focus on defensive equity, after accounting for the option premiums. In three of the five observable full years, ZWU has outperformed ZUT. In two of these cases, the degree of outperformance is 2.0% 2.5%, which should account for the yield spread. Once year-end distributions are calculated, 2016 would be expected to follow this pattern at current performance results. However, 2015 certainly was a step away from the ordinary. Markets had a terrible 2015 with the broad Canadian market as measured by XIC down 11.3%, Consequently, it was not surprising that ZWU was also down. What was surprising however, was the degree of underperformance when compared to ZUT. A contributing factor here was likely the exposure to energy stocks. Falling oil prices hurt pretty much any sector that had an association with the sector and investors were quick to lump in pipelines with traditional exploration and production names. 20.0% 10.0% 0.0% -10.0% -20.0% 16.9% 17.0% Calendar Year Performance 14.4% 12.4% 4.4% 3.9% 5.0% 1.6% 2.4% 14.8% YTD % -4.4% -15.2% ZUT ZWU Annualized Performance (net of fees) Our Final Thoughts Either of these two ETFs could be recommended for an income portfolio. The most appropriate choice simply comes down to what investors require from the investment. For those investors who require a higher level of income from their portfolio or who are simply looking to build diversified exposure to more than one defensive sector, ZWU would be a good fit. The additional yield received in exchange for an extra 10 bps in MER is certainly attractive. For the investor that desires strict exposure to the Canadian utility sector or a better combination of some dividends and some growth, ZUT would make more sense. Regarding the latter point, the absence of a covered call strategy will ensure the fund fully participates in sector rallies, where as ZWU would be expected to underperform as appreciating stocks are called away. 0.0% 1-year 2-year 3-year 5-year Since Inception ZUT 18.0% 6.7% 11.7% 5.6% 6.6% ZWU 7.9% -0.8% 6.6% N/A 4.8% Fund Details Fund code ZUT ZWU Price (2016/09/20) AUM ($M) Inception date: 19/01/ /10/2011 MER (%) Since inception return (%) Annualized distribution yield (%) OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on page 7 6

7 Portfolio Update: The Canadian MoneySaver ETF Portfolio By Michael Southern Since our last model portfolio update in June 2016, markets have trended higher and even touched all-time highs in the United States. However, over this period we have had our fair share of volatility. As we head into the final months of the year, we will look to capitalize on some gains and better position the Canadian MoneySaver portfolio for what lies ahead. All Eyes on the Federal Reserve (FED) Very much a will they, won t they story, timing the next rate hike from the FED has captivated investors since the last hike in December Investors are increasingly betting this will take place within a year, if not by year-end. This will be a headwind for gold, as higher interest rates increase the opportunity cost of holding the asset class. This point, along with stellar gains in the precious metal YTD has led us to sell our allocation in the Global Gold Index Fund (XGD). This will also help address the current overweight (15.4%) in the materials sector, a nice portfolio tailwind we enjoyed in The position will be replaced with US High Yield Bond Index Fund (XHY). We certainly like the income aspect from replacing an unproductive asset class with a position that yields 5.6%. Admittedly, any FED rate hike will likely hurt XHY in the short-term, as bonds with better credit become more attractive at a higher yield. However, over the medium-to long-term, as long as rates rise slow and steady in response to an improving economy, increased business will allow high yield debtors to service debt loads. Trade: Buy XHY (5.75%); Sell XGD (5.75%) The Best Offense is a Good Defense With a focus on the long-term investor, the model portfolio shows a growth asset mix with an approximately 75% equity allocation. This same tilt finds its way into the sector allocation with the financial, materials and industrial sectors being the top weights. Both the utility and telecommunication sectors combined represent less than 8.0% of the equity portfolio. We will increase the weight to these defensive sectors, given that market volatility appears to be here to stay a FED rate hike, presidential election, higher valuation multiples in equity, etc. We will be adding ZWU to help accomplish this mandate; you can read about the merits of the ETF in this issue s Fund Spotlight on page four. As this is predominantly a Canadian income focused ETF, we will be taking capital from CDZ to fund the trade, as well as a small weight from VE. We had hoped quantitative easing on behalf of the European Central Bank would have helped with a regional market recovery, similar to the success seen in US financial markets. However, fiscal policy is still a mess and the long-term impact from Brexit only complicates matters. Valuations are cheap and we continue to believe in a long-term recovery for the European region but also feel some capital could be better used elsewhere in the meantime. The net impact of this change should help limit exposure to sectors that are already well represented while adding some defensive allocations and diversification. Trade: Buy ZWU (5.00%); Sell CDZ (3.80%), VE (1.20%) Below we show the overall asset mix and sector allocation from the equity portfolio after making the above changes. OCTOBER 2016 ETF & MUTUAL FUND UPDATE Continued on Page 8 7

8 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Portfolio by Asset Class 73.33% 18.14% 4.82% 3.71% Equity Fixed Income Preferred Share Cash Equity Portfolio by Sector 25.00% 21.98% 20.00% 13.39% 15.00% 12.45% 9.15% 8.44% 10.00% 8.22% 7.38% 7.02% 6.03% 5.94% 5.00% 0.00% Financials Energy Industrials Technology Consumer Discretionary Materials Healthcare Consumer Staples Utilities Telecommunications Canadian MoneySaver MODEL ETF PORTFOLIO ETF Symbol Category Price Units Total % of Portfolio ishares 1-5 Year Laddered Corporate Bond CBO Fixed Income , % ishares DEX Universe Bond XBB Fixed Income , % ishares S&P/TSX Canadian Preferreds CPD Fixed Income , % ishares S&P/TSX Capped Composite XIC Equity: Canada , % ishares S&P/TSX Cdn. Div Aristocrats CDZ Equity: Canada Div , % ishares U.S. High Yield Bond Index ETF XHY Fixed Income , % Vanguard FTSE Emerging Markets Index VEE Equity: Emerging , % Vanguard FTSE Developed Europe All Cap VE Equity: Interntional , % SPDR S&P 500 SPY Equity: U.S , % Vanguard Div. Appreciation Index VIG Equity: U.S. Div , % ishares Russell 2000 Growth IWO Equity: U.S. Growth , % BMO Covered Call Utilities ZWU Equity: N.A. Div , % Cash Cash Cash 4, % Total Portfolio 121, Exchange Rate 1.31 $ Gain/(Loss): 21, Inception value: 100, % Gain/(Loss): 21.66% Inception date: October 18, 2013 % Annualized: 7.07% Prices are at market close on Sept. 30, Individual prices are in USD$. Portfolio values, $Gain/(Loss), % Gain/(Loss), % Annualized all reflect USD$ values are converted to CAD$ Current notes: as of Sept. 30 market close, sold XGD (5.75%), CDZ (3.80%), VE (1.20%); bought XHY (5.75%), ZWU (5.00%). Other notes: Keep in mind all investors are different. This portfolio is designed as a guide in setting up your own personal portfolio. Unique considerations and adjustments need to be made to reflect your personal situation. Please perform your own due diligence before making investment decisions. Question & Answer from 5i Research Question: Can you comment on preference of mutual funds: Investors Dividend-A (IGI283) and IG Beutel Goodman Canadian Balanced-A (IGI320). Answer: The dividend fund product is ok but likely provides little value when compared to a selection of cheaper ETFs. The fund charges a 2.39% MER, which is quite high. On an annualized 10-yr basis, the fund has underperfored the benchmark by 1.9%. Over the last five years, quarterly distributions vary around the $0.16-$0.21 range but have shown little growth. At the current NAV, the yield is roughly 3.5% superior to the broad Canadian market. There is also a 55% allocation to the financial sector. The top 10 holdings are roughy 55% of the fund for an average 5.5% weight and we like the higher conviction here. In regards to the balanced fund, other than the fact that the MER is expensive at 2.49%, this is a fine fund for one looking for active management with a balanced mandate. There is a 5.8% annualized return since inception, which is good for a balanced product. With 31% to bonds, there is a tilt to risk here that should be noted. Balanced funds often have a 40%-60% bond allocation. Bonds are mostly Canadian and there is a good balance between corporate/government issues. For the equity component, we like the sector allocation here (at least compared to the dividend fund) with financials accounting for 1/4 of the fund. OCTOBER 2016 ETF & MUTUAL FUND UPDATE 8