Fund manager Ryan Bushell continues to like utilities, renewable power producers, banks and oil and gas infrastructure
Ryan Bushell | July 13, 2021 | SmallCapPower: I greatly enjoyed reading Howard Marks’ memos during the depths of the market panic and subsequent recovery over the past year or so. In them he openly discussed his process of sorting through the uncertainty that gripped all of us in 2020. Of course, things are always uncertain in markets but I’ve taken one of Howard’s most used mantras to heart. We must move forward but with caution. One never knows what the future holds so we must do our best to prepare ourselves for the inevitable storms before they occur while remaining invested today. Everything seems stable or even positive now, and that is when investments are priced with the most risk to the downside. We can’t stop time so we must move forward, but with caution.
It is widely proffered that financial markets forecast 6-12 months into the future. When the effective vaccine trials were released in November markets began an ascent that has rarely faltered since. Despite an immense scientific and logistical challenge of vaccine production and distribution and two additional devastating waves of COVID 19 ahead, stocks climbed steadily higher, correctly forecasting the point we are at presently. It is reasonable now to ask what kind of environment we can expect 6-12 months into the future. The answer, of course, is uncertain and markets are beginning to reflect this uncertainty. The key debate for market participants at present centers on inflation. Specifically, whether the elevated year over year inflation numbers reported over the past few months are temporary, owing mostly to weak prices during the initial lockdown being lapped by stronger prices today, or if prices (and interest rates) will continue to rise for an extended period of years. Rarely has there been such fierce economic debate in the past few decades where inflation has been subdued and interest rates trended steadily downward.
I am not convinced we will see persistent inflation resulting in a sustained rise in interest rates in the near future. Stimulus and lockdowns allowed for a significant boom in durable goods demand as a substitute for services which were largely shuddered due to COVID 19 restrictions over the past 16 months. Durable goods demand is more inflationary than services because it requires more raw materials and higher priced labour to produce the desired output. It seems reasonable that we are on the verge of this demand cooling off as the service economy is poised to reopen more permanently and durable goods demand has been satisfied. This cooling of demand for “stuff” is likely to coincide with a significant reduction of stimulus from governments as emergency programs are scaled back and attention turns to balancing government finances, if only temporarily. The final pieces of the economic puzzle are central bank interest rate increases. Current expectations for the first interest rate increases in Canada and the United States have been moved up to late next year from 2024, which was the guidance as recently as February. Even small interest rate increases from extremely low levels will have a significant cooling effect given our extremely indebted economy. If the next 6 months play out something like the scenario detailed above, then we should see a slowdown in the economy which would likely impact investor sentiment negatively. Markets appear poised for a rest, and caution is warranted.
Looking ahead, caution on the broader markets is warranted at present. In the past 12 months the market has rapidly discounted effective vaccines being developed, a halving of interest rates, and fiscal spending stimulating durable goods demand that was on par with the late 1940s. Markets are likely to begin anticipating a more balanced picture with higher interest rates, reduced government spending, and reduced durable goods demand. This leaves markets vulnerable to a correction in the short to medium term, especially in the riskier sectors (technology/mining). Despite significant outperformance for Newhaven portfolios so far this year, I remain optimistic in the short, medium, and long term despite the potential economic headwinds discussed earlier. Keep in mind that the majority of our portfolio assets are concentrated in utilities, renewable power, banks and energy infrastructure. I have discussed my positive outlook on utilities and renewable power producers ad nauseum and a recent western North American heatwave serves as a second stark reminder this year that critical energy infrastructure is experiencing major stress and needs further investment. The investment case for banks is also relatively straightforward at present given valuations remain below their long-term average, expenses have been dramatically reduced by the pandemic, and outsized dividend growth is almost assured once the moratorium on dividend increases is lifted by the regulator in the coming months.
The outlook for oil and natural gas demand and prices has not been this strong since 2014 and warrants further discussion. Oil prices have climbed back above US$75/barrel, which equates to ~$93 Canadian dollars. This unbelievable turnaround from a year ago is a result of supply discipline from OPEC producers combined with underinvestment in non-OPEC producers, most notably the United States:
The chart above depicts the U.S. oil rig count over the past 5.5 years. The red line shows the current pace of oil drilling rig deployment and is tracking right around 400 rigs, similar to 2016 levels when oil prices were ~$10 lower. We are nowhere near the peak of 850 rigs reached in early 2019 and thus U.S. oil production has declined by more than 20% from 2019 levels. As global travel restrictions are eased, pent up demand is being released, which should keep consumption levels elevated for an extended period. Obviously, this assumption is made barring a resurgence in the virus, which unfortunately, cannot be ruled out. Upstream investment is extremely challenged at present despite high prices and surging demand, it stands to reason that global supply will remain constrained unless U.S. oil drilling rigs return to the 800 level, taking market share from OPEC. Meanwhile in Canada, we are adding pipeline capacity for the first time in a decade with the scheduled completion of the Line 3 and Trans Mountain expansions in the coming 6-12 months. These notable projects will allow for modest growth in volumes for our infrastructure providers and additional revenues for our price advantaged producers if the $C remains at or near current levels.
By far the more exciting, and material, development in our portfolios has been the significant rally in North American natural gas prices combined with major ongoing infrastructure expansions in Western Canada. Additionally, LNG Canada and other Natural Gas Liquids (NGL) export and processing facilities are moving rapidly toward completion throughout the 2020s, which will increase demand further. The rally in gas prices has been driven by global restocking in Europe and Asia following an extremely cold winter combined with increased domestic demand related to weather events and the industrial rebound.
The chart above depicts the extent to which spot natural gas prices (blue line) have increased since April of this year, a whopping 46%. Additionally, natural gas prices are substantially above average analyst price assumptions for the next 4 quarters of results. If the gas prices remain materially above the consensus expectation, we are likely to see continued strong performance from our natural gas holdings. Current prices, while potentially unsustainable, are a good indicator of the strength of underlying demand growth trending steadily higher. I outlined the positive thesis for natural gas prices and demand this summer during the December 2020 newsletter and that thesis has proved conservative so far. As owners of critical natural gas infrastructure we will continue to participate fully in natural gas demand growth with limited emphasis on natural gas prices.
In summary, the portfolio results so far this year have been outstanding. Although caution is warranted on the broader markets, we do not own the areas of the market that are most vulnerable to a sentiment driven correction resulting from a slowing economy. We continue to like utilities, renewable power producers, banks and oil and gas infrastructure. These sectors make up ~2/3 of our portfolio holdings, yield ~4% on average and steadily increase dividends over time. We will keep our eyes fixed on the horizon, understanding the unrelenting need for the critical infrastructure we own and the cash flow it produces.
Ryan Bushell is President and Portfolio Manager of Newhaven Asset Management Inc., where he focuses on meeting the needs of his individual clients. He has been a regular guest on several BNN Bloomberg programs, including Market Call, since 2011 and is a frequent contributor to the Globe and Mail, Toronto Star, Reuters and Bloomberg. He can be reached at firstname.lastname@example.org
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