The Lato Letter: Volume 3, Issue 12.

The Lato Letter: Volume 3, Issue 12.

As we approach the end of what has been a very good year for North American equity markets, the energy sector has fallen precipitously and as I write this issue, is still trying to find a bottom. The declines that we have seen thus far are reminiscent to the panic declines that we witnessed during the financial crisis in 2008-09. That was a very, very trying time that investors are still recovering from; but we did recover. There were many stocks that did not recover in that period but there also many other companies that incurred unwarranted dramatic declines but presented great opportunities for entry and/or continued investment in them.

With perfect hindsight, which unfortunately none of us has, the top in the energy sector was occurring around the time that I featured the four energy stocks in the quarterly “Summer” issue of The Lato Letter. There is no question that when you have an over 40% decline in the sale price of one of the end products that it will have an impact on the operations of all companies within the sector. However, the magnitude of the impact on the company often is greatly exaggerated by the move in the stock price under the current conditions where the proverbial “baby is being thrown out with the bathwater”.

The impact of low $60s or beyond oil will be felt on the four companies that were featured in the Summer issue mentioned above in order of magnitude from highest to lowest; Hi-Crush, Canyon, Parex and Tourmaline. The two companies serving the service end of the energy business will face the most uncertainty because exploration budgets will be cut impacting margins and revenues for both. Parex will face the next biggest impact because it is predominantly an oil exploration company and will directly feel the impact of lower oil prices and Tourmaline will be the least impacted because it is primarily a natural gas producer with the pricing of natural gas falling slightly but not nearly to the same magnitude as oil.

I am NOT contemplating selling any of these holdings at this time. Although there may continue to be short term volatility, all of these companies are leaders in their respective areas, well managed and conservatively financed and should come out of the current cycle in a much stronger position than the majority of their industry rivals. I will now quickly review the four companies.

Hi-Crush LP (HCLP-NYSE, $32.04)

v3_i12_hclp

Hi-Crush produces sand used in “fracking” during oil and gas explorations. The vast majority of its customers are in the United States where the economics of exploration are less favourable than they are in Canada. Hi-Crush is the enviable position of controlling deposits that are not only the highest quality but also the most accessible to rail transit.

Canyon Services Group (FRC-TSX, $7.63)

v3_i12_frc

Canyon supplies pressure pumping services by drillers in their horizontal and fracking operations. The company has chosen to supply only the Canadian market and thus is immune from any decline in the US market. While in the short term margins may suffer, unlike some its competitors the company is very conservatively capitalized and has very little debt making it better positioned to withstand any decline in Canadian drilling activity.

Parex Resources (PXT-TSX, $6.53)

v3_i12_pxt

Parex is an oil exploration and development company operating in Columbia that has enjoyed significant growth over the last several years. In 2011, Parex produced an average of 5345 barrels of oil equivalent per day(boe/day) and had proven and probable reserves of 10.7M boe. The company has recently guided to 2015 production of 28,500 to 30,000 boe/day and in the latest reserve report indicated proven and probable reserves of 57.6M boe. On both measures, Parex is roughly five times the size it was when a position in the stock was first taken by Padlock clients in early 2012 and yet the market capitalization today is essentially identical to that time. The other very important attribute of Parex is that the company is totally debt free making its 2015 capital exploration budget easily funded through internal cash flow and bank financing that is currently in place but not used.

Tourmaline Oil (TOU-TSX, $35.73)

v3_i12_tou

Its name does not depict things accurately since Tourmaline is an energy exploration and development company whose primary focus is not on oil but on natural gas. Unlike the large drop in oil prices, natural gas prices are down from their highs earlier in the year but not nearly at the same magnitude. Tourmaline has also enjoyed significant growth over the last few years. On a per thousand shares basis, in the year of its IPO in 2010, Tourmaline produced approximately 40 boe per 1000 shares per year and its current forecast for 2015 is to produce approximately 250 boe per 1000 shares per year. This sixfold increase in production per share has been accompanied by an approximately 70% increase in Tourmaline’s share price since the IPO, obviously leaving significant upside potential to narrow that gap once the sector stabilizes.

It has been a difficult few weeks, particularly in the energy sector but as I mentioned above I would not be a seller of any of the above holdings. Although I would delay making further commitments to either Hi-Crush or Canyon until clearer signs of a bottom in commodity prices are evident, I do feel that because of their financial and management strength longer term commitments can be considered for Parex and Tourmaline at these levels. With any commodity, supply and demand ultimately dictate the price and with lower oil prices creating increased demand and reducing supply by curtailing exploration plans, the old saying “the best remedy for a low oil price is a low oil price” should come in to play soon.

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change without notice.

To receive The Lato Letter by email from now on, please click here.



Padlock Investments is ready to take on your investment portfolio. Ask us how!