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Sector Scan: A Tale of Two Energy Markets

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Here in Ottawa, we rang in 2018 with a deep freeze as temperatures dipped to minus 20 degrees Celsius, and on some days below minus 30 degrees with the wind-chill factor. I have to confess that I’m not a big fan of the cold and wish the winters in our beautiful country were a bit warmer, but as a Canadian, the cold is in my blood. Most days during the deep freeze, just the thought of wrestling my car to start made me cringe.

It’s during these frosty periods that I find myself appreciating the creature comforts that many of us take for granted. Energy companies producing oil and natural gas provide me with heating for my home and fuel for my car, and improve my standard of living. While I’m hopeful for a greener future, the energy sector of old still makes me thankful.

U.S. crude on the rebound, while Canada struggles

After a rough start to 2017, oil prices had rebounded nicely to end the year. The West Texas Intermediate (WTI) price—the benchmark price for crude oil in the U.S.—ended the year at US$60.42 per barrel, up 12.5% from the beginning of the year. While this bodes well for oil producers, the rebound in oil prices did not translate into a good year for energy stocks around the globe, especially in Canada.

The S&P/TSX energy sector underperformed the core S&P/TSX Composite Index by 18.7% in 2017 (excluding dividends). Why such a large discrepancy? Well, while many quote oil prices using the WTI benchmark, most Canadian producers sell their oil at the Canadian oil benchmark price—Western Canadian Select (WCS).

WCS is Canada’s largest commercial heavy oil stream and was introduced in 2004 when four Canadian heavy oil producers (Suncor, Cenovus, Canadian Natural Resources and the former Talisman Energy) came together to address marketing and distribution complexities. The two most commonly used global benchmarks, WTI and Brent, are considered “light sweet” blends, which indicate higher quality compared to WCS, which is a “heavy sour” blend and is considered to be of a lower quality. Because of this difference in quality, WCS trades at a discount to WTI, and this discount fluctuates over time.

The great WTI-WCS divide of 2017

Over the past year, the discount between WCS and WTI initially contracted to about US$9 a barrel, and it remained range-bound between US$9 and US$12 through October. In November, though, the discount between WCS and WTI began to widen significantly. Most WCS is shipped to refineries on the U.S. Gulf Coast to be refined into useable products like gasoline. Due to competition with U.S. shale producers, this causes many transportation complexities for Canadian producers.

In November, TransCanada’s Keystone Pipeline was shut down for several weeks following a spill, and this caused a buildup of unrefined supply at Canadian oil producers. The pipeline bottlenecks are causing an imbalance between supply and demand, pushing the WCS price lower relative to the WTI price. The discount between WCS and WTI reached a four-year high of approximately US$27, causing a headache for Canadian producers and lower returns for shareholders.

Canadian producers were caught off guard by the transportation difficulties and scrambled to secure railway cars to send their oil to the refineries. This appeared to have helped slightly over the first two weeks of 2018 as the discount narrowed to US$21. However, the spread has widened again and is at US$28 as of January 26th. As more rail space is secured and pipelines return to full operation, analysts are predicting the spread will contract to approximately US$17 per barrel. This bodes well for Canadian producers as the price of selling their oil is expected to rise even if the WTI price stagnates and doesn’t move higher over 2018.

Natural gas hits negative territory

Meanwhile, natural gas faced price swings so extreme in 2017 that Canadian producers had to make some difficult choices: shut down their wells or sell their product for almost nothing. Things worsened in October, when the AECO spot price (Alberta’s benchmark natural gas price) hit negative territory for the first time, meaning producers were selling at a loss.

There was some hope that prices would recover with the deep freeze that led off 2018, but that optimism now appears to have been misplaced. This year’s heating season has been weak so far, and the issues that Canadian producers faced last year, like pipeline outages, don’t appear to be going away.

Caution: Speed bumps ahead

Although the outlook for Canada’s oil producers is looking up, we still expect challenges, and we’re not nearly as optimistic about the outlook for natural gas. All of this means that we’ll remain cautious of the energy sector until stronger signs of a turnaround emerge.

The energy sector has a significant impact on the Canadian economy and a material weighting in Canada’s main equity benchmark, the S&P/TSX Composite Index. On average, the sector had a 20.1% weight in 2017. In our Canadian equity funds and pools, we were generally underweight the energy sector, which was a positive contributor to performance relative to the benchmark.

In the MDPIM Dividend Pool, we were underweight the energy sector by 8.65% on average, which added 1.70% to excess returns. In the MDPIM Canadian Equity Pool, we were underweight by 2.46% on average, and this contributed 0.25% to excess returns. For our Canadian equity funds, our MD Select Fund was underweight the energy sector by 2.19% on average, which contributed to excess returns by 0.15%, while MD Equity Fund was underweight energy stocks by just 0.91% on average, which added only 0.09% to excess returns.

Even with a more promising outlook for Canadian producers, we’ll remain underweight until we see more evidence that transportation issues are resolved and that volatility and risk within the sector have come down to more historical levels. Once we see these signposts being met, then we’ll consider allocating more to the sector.

In the meantime, when the next deep freeze hits—which I’m sure is on its way—I’ll take comfort knowing I can turn up the heat, make myself a nice tall cup of hot chocolate and forget all about it.


About the Author

Edward Golding, CFA, MBA, was an Assistant Vice President with the Multi-Asset Management team at MD Financial Management. He oversees the Canadian, Dividend and U.S. equity mutual funds and investment pools at the firm.

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