Oil and gas strategy in the Anchor funds

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1 November 1 st, 2014 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor Oil and gas strategy in the Anchor funds Stock market outlook Equity markets have continued to be very volatile in the month of October. For example, the intraday swings in the TSX in October have averaged 214 points with a high on October 16 of 519 points and a low on October 3 of 111 points. This compares, for example, with the low volatility month of May. May saw intraday swings averaging 101 points with a high of 181 points and a low of 29 points. We would ascribe much of the increased volatility to the ending of quantitative easing in the U.S. combined with heightened concerns about the durability of global growth after an extended period of time without a major correction in North American equity markets. Canada has been additionally affected by the sharp decline in energy prices over the last couple of months. It is believed fears of global economic slowdown have affected investor perceptions of the potential demand for energy. Nevertheless, the general belief has been that the U.S. economy would continue to grow at a better pace than the rest of the developed world. However, even that comforting view might be under review, judging by the most recent reading for the ECRI Weekly leading Indicators (WLI), which dipped to a negative reading of 0.1%, the lowest since August This does not presage a U.S. recession (a negative reading of 10% would be required for evidence of that possibility) but it does suggest a greater degree of caution might prevail in the short term although possibly the prospect of slower U.S. economic growth could have been discounted in recent equity market weakness. Potentially offsetting this is the phenomenon of the four year U.S. Presidential cycle, which we have drawn readers attention to in recent months. Thus, November begins the once every four year sweet spot in the election cycle. The November to April period that begins in a mid-term election year has an exceptionally strong positive bias. This election cycle sweet spot has had a median return of 15.2% since The period has been positive 86% of the time and has not had a negative return since the period in Strategy in the oil and gas sector In our last Anchor Note, we made the following comments on the oil and gas and back end of cycle sectors: In hindsight, we would have done well to have taken profits in our holdings in the energy sector a couple of months ago. With additional modest positions in basic materials in the Anchor Dividend Growth and High Income funds, our overall exposure in those two funds has been moderately above 20%. Where do we go from here? Clearly, we have been surprised by the extent of the weakness in the oil price. Partly, that was due to the totally unexpected move by Saudi Arabia the world s swing producer to lower its price to Asian buyers to gain market share. Weakening global economic activity has impacted the demand side of the oil situation while, aside from Saudi Arabia, other OPEC producers including Iran have increased their discounts to Asian buyers to preserve their market share, thus increasing supply. Venezuela s oil minister has called for an emergency meeting of OPEC members (the next

2 formal meeting is not due until November 27) but this plea has so far fallen on deaf ears. Strength in the US dollar has also weighed on oil as it has with other commodities. However, recently Fed officials have been publicly questioning raising the Fed funds rate in the face of weaker global economic activity. This could halt the rally in the U.S. dollar in the short term although unlikely to change its long term upwards trajectory against the major currencies. Thus, with the WTI oil price on Tuesday October 14th trading down in the $81.90 area (on October 27, the WTI price was briefly down to about $79.50) which is getting close to the breakeven level for many U.S. shale oil producers, we could well see short term stabilization or even a modest recovery in the oil price and a bounce in energy stocks. Similarly, there have been fears in commodity markets about a hard landing in China. However, the September trade data, released on Monday October 13, showed that, on a seasonally adjusted basis, exports rose 3.1% month over month and 15.6% year over year to a new record high. Imports rose 11.7% month over month and 7.2% year over year. The copper price bounced off the $3.00 per pound level to $3.10 per pound the following day. In sum, we suspect that now is not the time to be cutting back our back-endof-cycle exposure but would review our weightings on any recovery in these stocks as the fourth quarter unfolds. In the intervening two weeks, we have become more concerned that the price of oil could stay depressed well into 2015 unless Saudi Arabia decided to reverse its recent change in position, which seems unlikely. In addition, in our opinion, the oil market was further influenced negatively by a widely quoted Goldman Sachs report on October 27, which suggested that the oil price could be a slow as $75 in the first quarter of 2015 and briefly at $70 a barrel. 1 This line of thinking forced us to consider the risk inherent in our oil and gas holdings at WTI prices of $75 and $70 a barrel. In the Anchor Defensive Income fund, we are precluded from investing in any oil and gas stocks since commodity stocks are prohibited in the equity segment. However, we examined all our oil and gas holdings in the other two funds in light of prospective oil prices at both $75 and $70 a barrel. All our holdings are what used to be Oil and Gas Royalty Trusts before the change in rules a few years ago. We elected to stress test each of the companies under the following constraints: maintaining a debt to cash flow ratio of 2.0 times or better at $75 a barrel prices and around 2.0 times at $70 a barrel WTI. For companies with natural gas production, we also assumed an AECO gas price of $3.50/mcf at both oil prices. We also screened for a simple dividend payout ratio of 50% or better at $70 a barrel oil prices and 133% or better if Capex was added to current dividends in order to calculate a total dividend payout ratio. We also screened to ensure that companies would not have drawn down their entire credit lines if they maintained their 2014 Capex programmes in 2015 and the WTI oil price fell to $70 a barrel. Under these screens, some of our current holdings in the various portfolios did not meet the stress tests. For example, in the $70 WTI and $3.50 AECO gas price scenario, Baytex s simple dividend payout ratio would be about 70% and its total dividend payout ratio would be close 200%. Under the same scenario, Bonavista s simple dividend payout ratio would be acceptable at around 40% - but its total dividend payout ratio would be over 170%. Under similar assumptions, we calculate that Canadian Oil Sands simple dividend payout ratio would be in excess of 80% and its total dividend payout ratio (using its July guidance for next year s growth Capex) would be about 130%. To varying degrees, therefore, all three of

3 the above would be at risk of cutting their current dividends under those price scenarios. In addition, we calculate that Bonavista would have drawn down all of its available credit lines and more in the lowest price scenario while Baytex would be dangerously close. Clearly, were prices to be at those levels, Capex programmes would be cut but that would reduce the production growth potential and the likely P/CF multiple. On a debt to cash flow basis, Canadian Oil Sands would likely see a ratio of about 2.0 times under the lowest price scenario but worryingly Baytex s debt to cash flow ratio would rise to about 4.0 times and Bonavista s to over 3.5 times. On the positive side, even under the $70 WTI ($80 Brent) scenario, both Vermillion and Peyto (although the latter is principally gas oriented) screen well. VET s simple dividend payout ratio would be less than 40% and Peyto s under 30%. On a total dividend payout ratio basis, VET s would be not much in excess of 100% and PEY s about 133%. In addition, both companies and especially Vermillion would have ample remaining credit lines upon which to draw and their debt to cash flow ratios would not exceed 2.0 times. In addition, we found that Arc Energy screens very well under these negative price assumptions. Its simple dividend payout ratio would be under 50% at $70 WTI. Its total dividend payout ratio would be about 190% and its debt to cash flow ratio would be modestly above 2.0 times. These parameters are, however, mitigated by the likelihood that its credit lines would not be drawn by 50% of its limit. There would likely be over $750 million of available credit lines on which Arc could draw. The net result of all these calculations prompted us to sell our holdings of Baytex, Bonavista and Canadian Oil Sands in the Anchor Dividend Growth and High Income funds. We retained Vermillion and concentrated our holdings in the two funds into Arc, Peyto and Vermillion. If there is a recovery in energy shares, the recovery in the ones we now own will be less than for those that we have sold. In addition, we have swapped three securities yielding 8% for a concentrated group yielding just over 4%. However, unless oil prices are headed a lot lower than the $70 price we have used in our calculations, there should be less volatility in the energy stocks we now own and we would be confident in their ability to maintain their dividends and, in Vermillion s case, to potentially increase its dividend despite low prices. The Anchor Defensive Income fund continues to benefit from its lack of commodity based equities and also its current level of equity exposure in the 37%-38% area. Nick Majendie, CA Director, Wealth Management, Senior Portfolio Manager, ScotiaMcLeod PLEASE NOTE: IMPORTANT DISCLOSURES AND DISCLAIMERS ARE CONTAINED ON THE FOLLOWING PAGE.

4 i The Bank of Nova Scotia is the parent company of Scotia Capital Inc. ( SCI ) and is therefore a related issuer of SCI. Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of SCI, is the manager of the Anchor. ScotiaMcLeod, a division of SCI is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaMcLeod, provides portfolio advice to the Funds. 1 Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaMcLeod or on Anchor hold securities of the following issuers referred to in this note: Arc Resources Ltd., Peyto Exploration and Development Corp., Vermillion Energy Inc. Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: Arc Resources Ltd., Peyto Exploration and Development Corp., Vermillion Energy Inc. This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice. The statements in this newsletter may contain statements related to future financial performance of certain securities, indices or the Anchor Managed funds that may constitute forward-looking statements. These statements may be identified by words such as expect, look forward to, anticipate, believe, seek, estimate, project, potential, predict, or words of similar meaning. Such statements are based on the current expectations and certain assumptions of

5 the author, and are, therefore, subject to certain risks and uncertainties. A variety of factors, many of which are beyond the author s control, affect the performance of the securities and capital markets indices and therefore the performance of the Anchor funds and could cause the actual results, performance or achievements of the securities, indices or the Anchor funds to be materially different.