In this issue:

  • Oil plunge hits dividends
  • Canadian interest rates in 2015
  • December’s Top Pick: Canadian Pacific 6.25% Guaranteed Notes
  • Gavin Graham’s updates: Canadian Oil Sands, Talisman Energy
  • December updates: National Bank Financial, Freehold Royalties, Keyera Corp., Inter Pipeline, Pembina Pipeline
  • Tom Slee, Deanne Gage move on

    • Next Update Edition: Jan. 15

    Next regular issue: Jan. 29

    OIL PLUNGE HITS DIVIDENDS

    By Gordon Pape, Editor & Publisher

    The sudden, dizzying fall in the global price of oil has already started to take its toll on income investors. Two of our recommended companies, Baytex Energy (TSX, NYSE: BTE) and Canadian Oil Sands (TSX: COS, OTC: COSWF) have announced dividend cuts and others may follow.

    It’s the prudent thing to do, of course. With cash flow expected to drop significantly next year, energy producers have to make the hard decisions necessary to stay afloat. Reducing payouts to shareholders and cutting capital expenses are the best way to do that. No one likes the idea but it’s better than seeing a company go under.

    Canadian Oil Sands, which holds the largest stake (36.74%) in the Syncrude project, was the first to move. It announced a dividend cut of 43% on Dec. 3, from the current quarterly rate of $0.35 per share ($1.40 annually) to $0.20 ($0.80 annually). Predictably, the share price plunged to below $10. The stock closed on Monday at C$8.60, US$7.39, which works out to a yield of 9.3% based on the new rate. That suggests investors believe another cut is possible before the bloodletting is done. See Gavin Graham’s update elsewhere in this issue for more details.

    Baytex announced its dividend cut on Dec. 8 and it was even bigger. Going forward, the monthly payout will drop to $0.10 per share ($1.20 per year). That’s down 58% from the $0.24 per share ($2.88 annually) that investors had been receiving. CEO James Bowzer said the move was needed to enable the company to manage its dividends “prudently to maintain strong levels of financial liquidity.”

    BTE shares also took a big hit. The stock is down about 70% from its June high of $49.88, closing on Monday at C$15.34, US$13.14. On the basis of the new dividend, the stock is yielding 7.8%.

    The stock looks oversold at this level, given the company’s good balance sheet and the fact it has hedged 41% of its exposure to West Texas Intermediate (WTI) crude for the first half of 2015. The hedging program consists of 29% fixed at US$96.47/bbl and 12% receiving the WTI price plus US$10.91/bbl when WTI is below US$80. For the second half of 2015 the company has entered into hedges on approximately 12% of its net WTI exposure with 8% fixed at US$95.98/bbl and 4% receiving WTI plus US$10/bbl when WTI is below US$80.

    However, at this stage we’re still in the eye of the hurricane. We don’t know how far the oil price will fall (some analysts are now talking US$40) or how long the low prices will last. As a result, investors are bailing out of energy stocks as fast as they can. In the few minutes it took me to write these paragraphs on Friday morning, Baytex shares fell $0.30.

    There will be a time when Baytex and other energy companies become screaming bargains and my sense is we’re getting near that point. But we need to let this drama play out before starting to bottom feed.

    My general advice is to maintain your energy positions, unless you want to sell for a tax loss. However, a few buying opportunities have already emerged in related industries; see the updates section for more details.

    The situation reminds me of the sell-off in the financial sector in the fall and winter of 2008-09. It took about six months for the scenario to unfold and reach its selling climax in early March. At that point, every Canadian bank stock was a screaming bargain. It could take at least as long for the energy sector to find a bottom. Get ready for a long haul.

     

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    CANADIAN INTEREST RATES IN 2015

    By Tom Slee, Contributing Editor

    After years of moving sideways in lockstep, U.S. and Canadian interest rates may be parting company. Resurgent consumer spending and strong job creation are putting upward pressure on our neighbour’s rates. Meanwhile, here in Canada our recovery continues to splutter and an oil glut is going to inflict more damage. We may need lower, not higher, interest rates in 2015.
    At long last the U.S. economy is coming to life. According to the Commerce Department, third quarter growth came in at 3.9%. Following on the heels of 4.6% (adjusted) in the previous quarter, it produced the strongest six-month performance in more than a decade. And we still have the year- end shopping frenzy numbers to come.

    Falling energy prices will give an additional lift. The average price for a gallon of regular gasoline in some states has dropped to US$2.65, down 33 cents from a month ago. Since the average American household consumes 1,200 gallons a year the impact is substantial. Adam Slater, senior economist at Oxford Economics, believes the recent drop in oil prices, if sustained, could add almost 0.5% to U.S. GDP growth in the coming year.

    Of course, we have had false starts before but this time the strength seems broadly based. Not only has consumer confidence improved, but all-important business investment is picking up. Non-residential building has been growing at 7.1% while equipment spending is up 10.7%. Companies are making long-term commitments and sometime soon the Federal Reserve is going to step in and gradually apply the brakes by raising its overnight Fed Funds rate. We could see a hike during the next few months but my own feeling is Chair Janet Yellen will wait until later in 2015 to see whether employment figures are sustained.

    In Canada, we have a different situation. Until a few weeks ago I thought the Bank of Canada would also increase short-term rates, perhaps in May, even though our growth remains relatively weak. Now, with oil below US$70 a barrel and likely to remain weak, the prospect of a rate increase has faded.
    Finance Minister Joe Oliver’s 2015 forecast of 2.8% GDP growth has been trimmed but still assumes an average oil price of US$81 per barrel. When challenged, Mr. Oliver was flippant and said that “what I lose at the pump I gain in the mall.” That is not going to happen. We depend on oil exports. Capital Economics economist David Madani estimates we could lose $11 billion of exports in 2014 alone, worth 0.6% of GDP because of falling energy prices since June. We need stimulus. Canada may have to cut interest rates, not increase them.

    Here is my forecast for the coming year.

    U.S. rates: Overnight Fed Funds currently 0.10%, by year-end 1.25%; 10-year Treasury Bills currently 2.3%, by year-end 3.5%; and 30-year Treasury Bills currently 3%, by year-end 4%.

    Canadian rates: Overnight Funds currently 1%, by year-end 1%; 10-year Canada bonds currently 2%, by year-end 2.25%; and 30-year Canada bonds now 2.5%, by year-end 2.85%.

    In short, Canadian interest rates are likely to move sideways in 2015, while U.S. rates climb decisively. We have to keep in mind that the Fed will continue to guide markets and historically the Fed has moved its Fund rate three full percentage points in a year when pushing hard. Using that as a yardstick, something like a one-third throttle seems right in the present situation. That would give us an overnight rate of about 1.25% by the end of 2015 and 2% or more by December 2016.

    As far as Canadian income investors are concerned, bonds are going to remain unattractive. Even long term corporate yields currently in the 4.5% range provide insufficient income for most people’s needs. My suggestion, therefore, is staying with high quality preferred shares and real estate investment trusts (REITs) in the coming year. Use the yield on two-year GICs as a guide but keep in mind these certificates come with strings. Your money is essentially locked-in by call features carrying severe penalties. For example, Scotiabank is offering 2% on its 24-month GIC. If you cash it in though, the rate is far less. As a matter of fact there is no interest paid on redemptions during the first 30 days. Highly liquid RioCan REIT trading at $27.30 and paying a reliable $1.41 distribution to yield 5.2% is a much better bet if you can assume a modicum of risk.

    Having said that, there is some light at the end of the tunnel for Canadian investors who prefer to hold at least some bonds in their portfolios. I think once oil prices stabilize, perhaps by the third quarter, the Bank of Canada will be in a hurry to raise rates if only to protect our shrinking loonie. Higher yields are in the offing even though they will not be apparent until early 2016. Therefore, it’s time therefore for bondholders to start adjusting their holdings to prepare for the change. Here are some suggestions.

    Start by shortening term. The worst place to be when rates are rising is in long bonds with low coupons. They drop significantly in value because the small current cash flow provides little cushion. Conversely a two- or three-year bond with a substantial coupon rate will move hardly at all. At the same time adjust your bond ladder, a strategy whereby some bonds mature each year over a five year span in order to provide continuing liquidity and allow reinvestment of maturing capital at hopefully better rates. Shorten the span to four or even three years.

    Avoid good-quality floating rate securities for now. They are an obvious option but their current yields are extremely low. For example, Power Financial A Floating Rate Preferred Shares (PWF.PR.A) are trading at $19.60 and paying a $0.53 dividend to yield 2.7%. Distributions are linked to the Canadian Prime Rate, which is expected to remain virtually unchanged for most of 2015. Even if there is an upward adjustment, investors will have to wait as much as another quarter until Power’s directors declare the next dividend.

    Look at relatively short blue chip corporate bonds. We are starting to see a yield spread between these issues and government securities. Also opt for higher coupons so that there is downside protection. For a good example, see my Top Pick in this issue.

     

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    DECEMBER’S TOP PICK

    Here is our Top Pick for this month. Prices are as of the close of trading on Monday, Dec. 15 unless otherwise indicated.

    Canadian Pacific Railway 6.25% Medium Term Notes Maturing June 1, 2018

    Type: Guaranteed notes
    Recent price: $112
    Entry level: Current price
    Yield to maturity: 2.08%
    Credit rating: S&P: BBB Conservative, DBRS: BBB (High)
    Risk rating: Conservative
    Recommended by: Tom Slee

    The business: Canadian Pacific Railway, a Canadian icon, was founded in 1881 and spun off from Canadian Pacific Limited in 2001. It owns and operates rail and freight transportation services over a 14,400-mile network linking more than 1,100 communities extending from Montreal to Vancouver and through the U.S. Midwest and Northeast. Market capital exceeds $39 billion and expected revenues of $6.7 billion this year should generate an operating profit in the $2.8 billion range.

    The security: The 6.25% Notes are direct obligations of Canadian Pacific Railway and mature on June 1, 2018. CPR can call these notes at any time at a price that provides a yield equal to the current return on five-year Canada bonds plus 65 basis points. At the present time, with five-year Canada issues paying 1.43%, the redemption price is approximately $121.

    Why we like it: With positive changes at CPR now well underway, these notes are essentially investment-grade caliber, yet they yield about 140 basis points more than most top quality corporate bonds. In addition, they are relatively short term and the 6.25% coupon provides protection against a large unrealized loss in the unlikely event medium-term interest rates start moving sharply higher.

    Credit rating: The notes are rated BBB (High) by Dominion Bond Rating Service (DBRS) and BBB by Standard & Poor’s. Moody’s has a Baa2 rating on the issue.

    Risks: A substantial, prolonged economic downturn could impact the company’s ability to service this debt. This is extremely unlikely.

    Distribution policy: Interest payments of $31.25 per $1,000 face value are made on June 1 and Dec. 1 each year.

    Tax implications: The interest payments are taxable in the year received for Canadian investors who hold the notes outside a registered plan. Any profit or loss from sale, redemption or maturity is taxed as a capital gain or loss in the year when the notes are disposed.

    Who it’s for: The CPR 2018 Notes are suitable for investors who need secure income and guaranteed return of capital as well as an above average return.

    How to buy: The notes are thinly traded in the Canadian corporate bond market. Set a limit and if necessary wait for your fill.

    Action now: Buy at $112. – T.S.

     

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    GAVIN GRAHAM’S UPDATES

    Oil prices are still struggling to find a bottom. Every day brings a new low, with the price of West Texas Intermediate (WTI) crude falling to below $54 on Dec. 16 (figures in U.S. dollars). Brent crude, the international benchmark, was under $60. Prices have been falling for more than five months, as Brent was trading as high as $115 a barrel as late as June this year.

    The sharp decline was driven by a bearish forecast on Dec. 5 by Morgan Stanley analyst Adam Longson. He slashed his 2015 forecast for Brent crude by $28 a barrel (30%) to $70 from $98, with the possibility of oil prices dropping as low as $43 a barrel at some stage during the year. “Without OPEC (Organization of Petroleum Exporting Countries) intervention, markets risk becoming unbalanced, with peak oversupply likely in the second quarter of 2015,” Mr. Longson wrote.

    So far, notes the Globe and Mail, there seems little chance of intervention, after OPEC declined to cut production at its meeting in Vienna on Nov. 27, since when oil prices slumped by more than $12 a barrel (15%).

    The rout was reinforced by comments by the CEO of OPEC member Kuwait’s national oil company, who remarked that oil prices were likely to stay around $65 a barrel for the next six to seven months, another sign that the low cost Persian Gulf producers such as swing producer Saudi Arabia, Kuwait, the United Arab Emirates and Iraq are quite content to have a period of lower prices. With oil down over 40% since June, the established producers are clearly prepared to endure lower prices for a prolonged period. They can afford to do so, with their production costs averaging below $50 a barrel.

    The situation is much more serious for higher cost producers such as Russia and OPEC members Venezuela and Iran, where oil and gas revenues are responsible for over 75% of government revenues. The collapse of the ruble and Venezuelan bolivar over the last few months has been much worse than that of other emerging market currencies that are not so dependent upon energy revenues.

    Of course, this has meant serious consequences for North American oil and gas companies. Some commentators believe that the refusal by OPEC to cut oil production and allow the oil price to slide is a tactic designed to counteract the threat to their revenues from the growth of U.S. shale oil and gas production, which has resulted in the U.S. becoming an energy exporter for the first time since the early 1970s. As many shale oil fields are relatively high cost to drill and their production declines fairly sharply, with over half the reserves in a typical field extracted within two years, there has always been a concern about their sustainability in the long term.

    Should oil prices remain in the $65 to $75 a barrel range for any length of time, much of the anticipated growth in production will become loss making and end up not being drilled. This would both affect U.S. GDP growth and its trade balance, which has been recovering sharply as domestic oil and gas production has replaced imports, including those from Canada. For the moment, the U.S. dollar has been riding high, up 12% on a trade-weighted basis since May and nearing the level, which would represent a breakout from a 25-year downward trend.

    This has helped keep the price of imports subdued and inflation under control, and has acted as an effective tightening measure, relieving the U.S. Federal Reserve from the necessity of raising interest rates any time soon, even though unemployment keeps falling and U.S. wage growth is finally picking up. Falling gasoline prices, of course, are an effective tax break for consumers, and in states with low gas taxes such as Oklahoma, a gallon of premium gas touched $2 this week, a level not seen since the late 1990s.

    Not surprisingly, this all meant an awful performance for energy stocks, and other commodity producers as well. On Dec. 15, the S&P/TSX Composite fell 3.1%, led by the S&P/TSX Capped Energy Index, which fell an amazing 7.2%, the most since August 2011, as crude dropped to a five-year low. At that point, the TSX Composite had dropped 11.4% since hitting a five-year high at the beginning of September, wiping about C$300 billion off the value of stocks and dropping its return for the year to only 0.6%. Having been the second best performing developed market through the end of June, Canada now ranks only 16th, driven down by energy, off 30% year-to-date and materials, off 10%.

    With the banks being hit by lower-than-forecast earnings growth when they reported at the beginning of December, the financial sector has slid 5.8% since November, leaving them only up 4% for the year. As energy, materials and financials account for two-thirds of the TSX Composite’s market capitalization, it will be hard for the index to make headway until the fall in commodity prices stops, especially as the banks’ bad debts due to their energy exposure and related sectors such as oil services, housing and transport in the western provinces will doubtless increase.

    Canadian GDP growth, already slowing from 3.6% in the second quarter to 2.8% in the third, will also be hit. The 10,700 increase in unemployment, with the rate rising to 6.6% in November, may be a precursor of the slowdown. However the weaker loonie, off about 10% against the U.S. dollar this year, may help counteract some of the negative effects by making Canadian exports cheaper and more competitive.

    Lastly, energy companies are responding by slashing their capital expenditures, thus leading to further weakness in business investment. ConocoPhillips, the U.S. oil major, reduced its 2015 capital expenditure budget by 20% to $13.5 billion while Precision Drilling, Canada’s largest oils services company, virtually halved its 2015 budget to $493 million from $885 million this year.

    Let’s see how this dramatic change in oil prices has affected my oil exploration and production recommendations.

    Canadian Oil Sands (TSX: COS, OTC: COSWF)

    Type: Common stock
    Trading symbols: COS, COSWF
    Exchanges: TSX, OTCQX
    Current price: C$8.60, US$7.39
    Originally recommended: Mar. 23/05 at C$16.85
    Annual payout: $0.80
    Yield: 9.3%
    Risk Rating: Moderate risk
    Recommended by: Gavin Graham
    Website: www.cdnoilsands.com

    Comments: On Dec. 4, Canadian Oil Sands announced a 42% reduction in its dividend from $0.35 a quarter to $0.20 when it announced its 2015 production forecast. This caused the stock to plunge to a 10-year low of just under $11. It’s fallen more since then.

    CEO Ryan Kubik forecast production from Syncrude to be between 95 million to 110 million barrels, up from the lower end of the 2014 production of 95 to 100 million, but with an average oil price of $75 a barrel in 2015. Capital expenditure would fall from $1.1 billion to $564 million as major spending projects wrap up. But operating expenditure would be higher at $1.7 billion against $1.6 billion, equal to $45.69 a barrel. This would mean that debt for Canadian Oil Sands would rise to over $2 billion, the top end of the desired range. Therefore, the company decided to cut in the dividend. This should mean that the free cash flow of $730 million ($1.51 per share) in 2015 is sufficient to produce a payout ratio of less than 60%.

    Canadian Oil Sands has always made it clear that the dividend level was dependent upon the price of oil. With the recent sharp fall, it has been conservative in setting its payout ratio. It did so when it reduced its dividend back in 2008-09 and subsequently increased the dividend back up to $0.35 a quarter. However, the present sell-off in the share price, a fall of 60% in six months more than reflects all the bad news.

    Action now: Unless investors want to realize tax losses this year, Hold until the price of oil has stabilized, at which point we will revisit. – G.G.

    Talisman Energy (TSX, NYSE: TLM)

    Type: Common stock
    Trading symbols: TLM
    Exchanges: TSX, NYSE
    Current price: C$5.97, US$5.12
    Originally recommended: Jul. 31/14 at C$11.72
    Annual payout: US$0.27
    Yield: 4.5%
    Risk Rating: Higher risk
    Recommended by: Gavin Graham
    Website: www.talisman-energy.com

    Comments: I recommended Talisman four months ago because the ex BP Canada operation was a cheap, underperforming exploration and production company that was being turned around by former TransCanada CEO Hal Kvisle. The stock has since fallen by more than half, an astonishing collapse for a company, which is still cash generative and now has a suitor in the form of Repsol, a Spanish state controlled oil company.

    On Dec. 15, Repsol agreed to buy Talisman for $9.33 a share, equivalent to US$8.3 billion. While this is a 60% premium to the weighted average price over the last 30 days, it is still 25% below my original recommendation, a sign of how rapid and severe the decline has been with oil stocks. This compares with an average premium of 38% for similar-sized targets in the sector over the last three years. Holders should accept the offer, unless they wish to realize a tax loss this year by selling in the market.

    Repsol is flush with cash after finally receiving the proceeds of its nationalized Argentinean subsidiary YPF this spring.

    As I mentioned back in July, one of the drags on Talisman has been its underperforming North Sea assets, where its 50/50 joint venture with China Petroleum Corp when it sold a half share in its assets in 2012 requires it to spend US$2.5 billion over five years. The market is expecting these assets to be written down before year-end, together with other Talisman assets in the Norwegian North Sea and Kurdistan.

    Nonetheless, selling at less than half its book value and 0.8 times its 2014 sales, Talisman’s share price reflects all of the bad news and much more. The company has completed US$2 billion of sales in 2012-13, has a strong balance sheet (under 55% net debt/equity at end Q3 2014) and investment grade status, and $2 billion of cash flow in 2014.

    Action now: Hold. Talisman will be very volatile until the deal closes and it may yet fall apart. Investors willing to buy Talisman and put up with the volatility of a takeover will make over 50% at the present price of $5.97 if the deal goes through. – G.G.

     

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    DECEMBER UPDATES

    Here are the updates for this month. Prices are as of the close of trading on Monday, Dec. 15, unless otherwise stated.

    National Bank Financial (TSX: NA)

    Type: Common stock
    Trading symbols: NA, NTIOF
    Exchanges: TSX, Pink Sheets
    Current price: C$45.83, US$39.70
    Originally recommended: Mar. 22/06 at C$63.69, US$55.44
    Annual payout: $2
    Yield: 4.4%
    Risk Rating: Conservative
    Recommended by: Tom Slee
    Website: www.bnc.ca

    Comments: National Bank reported unexciting 2014 fourth-quarter earnings of $1.14 a share, in line with expectations, and $4.31 for the fiscal year. The numbers were a mixed bag. Profit of its wealth management division jumped 29% year over year but all-important commercial and residential loans were up only 7%. As a result, the bank is on track to earn about $4.65 a share in the coming year.

    National has worked out very well for us and trades at $45.83, a 44% gain from our recommendation at $31.80. Canadian banks, however, are entering a difficult period as lower commodity prices impact corporate lending and domestic retail business slows. Their stocks are likely to move sideways for a while. Therefore, while NA remains an excellent bank I think we should take our profits at this stage and use the money better elsewhere.

    Action now: Sell. – T.S.

    Freehold Royalties (TSX: FRU, OTC: FRHLF)

    Type: Common stock
    Trading symbols: FRU, FRHLF
    Exchange: TSX, Pink Sheets
    Current price: C$17.27, US$14.87
    Originally recommended: Feb. 22/12 at C$20.37, US$20.51
    Annual payout: $1.68
    Yield: 9.7%
    Risk Rating: Higher risk
    Recommended by: Gordon Pape
    Website: www.freeholdroyalties.com

    Comments: Freehold didn’t escape the energy sector meltdown but the damage was less due to the nature of the business. Freehold is a primarily a royalty company, which means it doesn’t have the high capital expenses of exploration and production firms.

    That doesn’t mean it is immune to a drop in oil prices, of course, but the effect is somewhat more muted, which explains why the stock has held up better than most.

    The company has not made any announcement about its dividend, which currently stands at $0.14 per month ($1.68 per year) to yield 9.7% at the current price. However, a cut at some point cannot be ruled out. RBC Capital Markets said in a mid-November analysis that the dividend looked stable at a WTI price of US$86.50, with a 2015 payout ratio of around 90%. However, the oil price is now well below that level and may not yet have hit bottom. Freehold’s board of directors will have to make some tough decisions early in the New Year.

    In the meantime, the company has been actively making new deals, with a total value of almost $50 million. In the largest one, Freehold will take over most of the assets of Anderson Energy Ltd., which the company says are expected to contribute 350 barrels of oil equivalent per day (boe/d) of mostly working interest natural gas production to Freehold’s 2015 production. Cost to Freehold is $35 million. The other three deals, one joint venture and two royalty arrangements, will add another 400 boe/d.

    Action now: The stock becomes a Hold while we wait for the oil price to settle and for a dividend decision. – G.P.

    Keyera Corp.

    Type: Common stock
    Trading symbols: KEY, KEYUF
    Exchanges: TSX, Grey Market
    Current price: C$69.70, US$60.37
    Originally recommended: July 22/04 at C$12.05
    Annual payout: $2.58
    Yield: 3.7%
    Risk Rating: Higher risk
    Recommended by: Gordon Pape
    Website: www.keyera.com

    Comments: A month ago, Keyera shares were trading at over $90. Now they have fallen to less than $70. Obviously, the stock was another casualty of the fall in the price of oil but in this case the sell-off seems to have been overdone. The company is primarily in the natural gas and natural gas liquids (NGL) business. It’s a midstream operator, providing such services as gathering, processing, fractionation, storage, transportation and marketing. It does not do any exploration or production.

    The company is having a great financial year. Third-quarter earnings came in at $82.4 million ($0.98 per share), more than double the $40.8 million ($0.52 per share) reported in the same period of 2013. Distributable cash flow was a record $124.4 million ($1.48 per share) compared to $50.5 million ($0.64 per share) recorded in the third quarter of 2013. That provides a healthy cushion for the monthly dividend of $0.215 per share ($2.58 per year). That doesn’t mean Keyera shareholders are immune from a dividend cut but based on this year’s financials and the company’s limited exposure to oil prices it seems unlikely.

    When I last updated this stock in June it was yielding 3.3%. That had dropped to 2.6% when the shares hit an all-time high of $99.84 in early September. However, the pullback in the stock price has pushed the yield back up to a more attractive 3.7%.

    Action now: Buy under $65. I think the stock has already sold off too much but if it falls to below $65, the yield will be up to 4%. At that level, it’s hard to resist. – G.P.

    Inter Pipeline (TSX: IPL, OTC: IPPLF)

    Type: Common stock
    Trading symbols: IPL, IPPLF
    Exchange: TSX, Grey Market
    Current price: C$29.02, US$25.14
    Originally recommended: Oct. 21/09 at C$9.99, US$9.62
    Annual payout: $1.47
    Yield: 5.1%
    Risk Rating: Moderate risk
    Recommended by: Gordon Pape
    Website: www.interpipeline.com

    Comments: Any company associated with the energy sector is being punished these days, even innocent bystanders. Inter Pipeline, which has been so good to us since I recommended it in 2009, comes close to falling into that category. The share price has dropped about $10 since its September high of $38.95, with most of the retreat occurring in the last three weeks. This happened despite the fact the company announced a record dividend increase of 14% in early November, bringing the monthly payment to $0.1225 per share ($1.47 annually). That’s up from $0.1075 per month ($1.29 a year). Based on the current price, the enhanced dividend provides a juicy yield of 5.1%.

    CEO Christian Bayle described the increase as “clear evidence that our business has never been stronger. So far this year, Inter Pipeline has commissioned $1.2 billion of new pipeline assets, with a further $1.8 billion targeted to enter full commercial service in early 2015.”

    It appears some investors are concerned that Inter’s pipeline volume could be negatively affected by the oil price decline, resulting in reduced revenue. The company operates about 6,400 kilometres of petroleum pipelines and 4.8 million barrels of storage in Western Canada. Much of the throughput is oil sands production, which amounted to 942,300 barrels per day in the third quarter. It’s the largest segment of the company’s business, generating $82.5 million in funds from operations, or about 59% of the total. So there is some vulnerability if oil sands output should diminish due to low prices.

    However, I see this risk as minimal. Inter has firm contracts with major producers and is investing $3.1 billion to expand its oil sands transportation infrastructure.

    Action now: The stock is a Buy for more aggressive investors who are prepared to assume some risk in a volatile market. Otherwise, Hold. – G.P.

    Pembina Pipeline Corp. (TSX: PPL, NYSE: PBA)

    Type: Common stock
    Trading symbols: PPL, PBA
    Exchanges: TSX, NYSE
    Current price: C$36.83, US$31.90
    Originally recommended: June 24/09 at C$14.77
    Annual payout: $1.74
    Yield: 4.7%
    Risk Rating: Moderate risk
    Recommended by: Gordon Pape
    Website: www.pembina.com

    Comments: Pembina has also experienced a drop in its share price, from an all-time high of $53.04 in September to the current level of $36.83. That’s a retreat of about 15%, which is nowhere near as severe as the pullback in the shares of Inter Pipeline.

    The reason is that Pembina has less exposure to the oil sands. Net operating revenue from oil sands and heavy oil in the third quarter was $52 million or less than 15% of total operating income. The company’s midstream operations ($139 million) and conventional pipelines ($128 million) account for the lion’s share of the income.

    Third-quarter net income came in at $75 million ($0.20 per share). In dollar terms that was up from $72 million last year but on a per share basis earnings were down two cents. For the first nine months of the fiscal year, the company reported earnings of $299 million ($0.85 per share), up from $256 million ($0.83 per share) last year. Adjusted cash flow from operating activities was $613 million ($1.90 per share) compared to $540 million ($1.77 a share) in 2013. The dividend payout was $1.29 per share for a payout ratio of 68%.

    I do not see any immediate concern about the dividend, which is currently $0.145 per month ($1.74 annually). Because of the retreat in the share price, the current yield is 4.7%.

    Action now: Hold. The pullback in the share price is not enough to push this into the Buy column just yet. – G.P.

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    TOM SLEE, DEANNE GAGE MOVE ON

    As those who subscribe to our companion Internet Wealth Builder newsletter already know, contributing editor Tom Slee is retiring as of Dec. 31. Tom has been a mainstay of this newsletter almost from the time it was launched and his expertise on fixed-income securities will be missed. I’m sure all our readers join me in thanking him for his contributions and in wishing him many happy and healthy years in retirement.

    We are also saying good-bye to associate editor Deanne Gage, who is leaving the position to spend more time with her family. Readers may not be familiar with Deanne, who works behind the scenes, but she has been a pillar of strength in helping to pull together every issue and to ensure our editorial content meets the highest standards. We wish her well in her future endeavors.

     

    That’s all for this issue and for 2014. Look for your next Update Edition on Jan. 15. The next regular issue will be published on Jan. 29. Best wishes for the holiday season to all our readers.

    Best regards,
    Gordon Pape

In this issue:

  • Oil plunge hits dividends
  • Canadian interest rates in 2015
  • December’s Top Pick: Canadian Pacific 6.25% Guaranteed Notes
  • Gavin Graham’s updates: Canadian Oil Sands, Talisman Energy
  • December updates: National Bank Financial, Freehold Royalties, Keyera Corp., Inter Pipeline, Pembina Pipeline
  • Tom Slee, Deanne Gage move on

    • Next Update Edition: Jan. 15

    Next regular issue: Jan. 29

    OIL PLUNGE HITS DIVIDENDS

    By Gordon Pape, Editor & Publisher

    The sudden, dizzying fall in the global price of oil has already started to take its toll on income investors. Two of our recommended companies, Baytex Energy (TSX, NYSE: BTE) and Canadian Oil Sands (TSX: COS, OTC: COSWF) have announced dividend cuts and others may follow.

    It’s the prudent thing to do, of course. With cash flow expected to drop significantly next year, energy producers have to make the hard decisions necessary to stay afloat. Reducing payouts to shareholders and cutting capital expenses are the best way to do that. No one likes the idea but it’s better than seeing a company go under.

    Canadian Oil Sands, which holds the largest stake (36.74%) in the Syncrude project, was the first to move. It announced a dividend cut of 43% on Dec. 3, from the current quarterly rate of $0.35 per share ($1.40 annually) to $0.20 ($0.80 annually). Predictably, the share price plunged to below $10. The stock closed on Monday at C$8.60, US$7.39, which works out to a yield of 9.3% based on the new rate. That suggests investors believe another cut is possible before the bloodletting is done. See Gavin Graham’s update elsewhere in this issue for more details.

    Baytex announced its dividend cut on Dec. 8 and it was even bigger. Going forward, the monthly payout will drop to $0.10 per share ($1.20 per year). That’s down 58% from the $0.24 per share ($2.88 annually) that investors had been receiving. CEO James Bowzer said the move was needed to enable the company to manage its dividends “prudently to maintain strong levels of financial liquidity.”

    BTE shares also took a big hit. The stock is down about 70% from its June high of $49.88, closing on Monday at C$15.34, US$13.14. On the basis of the new dividend, the stock is yielding 7.8%.

    The stock looks oversold at this level, given the company’s good balance sheet and the fact it has hedged 41% of its exposure to West Texas Intermediate (WTI) crude for the first half of 2015. The hedging program consists of 29% fixed at US$96.47/bbl and 12% receiving the WTI price plus US$10.91/bbl when WTI is below US$80. For the second half of 2015 the company has entered into hedges on approximately 12% of its net WTI exposure with 8% fixed at US$95.98/bbl and 4% receiving WTI plus US$10/bbl when WTI is below US$80.

    However, at this stage we’re still in the eye of the hurricane. We don’t know how far the oil price will fall (some analysts are now talking US$40) or how long the low prices will last. As a result, investors are bailing out of energy stocks as fast as they can. In the few minutes it took me to write these paragraphs on Friday morning, Baytex shares fell $0.30.

    There will be a time when Baytex and other energy companies become screaming bargains and my sense is we’re getting near that point. But we need to let this drama play out before starting to bottom feed.

    My general advice is to maintain your energy positions, unless you want to sell for a tax loss. However, a few buying opportunities have already emerged in related industries; see the updates section for more details.

    The situation reminds me of the sell-off in the financial sector in the fall and winter of 2008-09. It took about six months for the scenario to unfold and reach its selling climax in early March. At that point, every Canadian bank stock was a screaming bargain. It could take at least as long for the energy sector to find a bottom. Get ready for a long haul.

     

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    CANADIAN INTEREST RATES IN 2015

    By Tom Slee, Contributing Editor

    After years of moving sideways in lockstep, U.S. and Canadian interest rates may be parting company. Resurgent consumer spending and strong job creation are putting upward pressure on our neighbour’s rates. Meanwhile, here in Canada our recovery continues to splutter and an oil glut is going to inflict more damage. We may need lower, not higher, interest rates in 2015.
    At long last the U.S. economy is coming to life. According to the Commerce Department, third quarter growth came in at 3.9%. Following on the heels of 4.6% (adjusted) in the previous quarter, it produced the strongest six-month performance in more than a decade. And we still have the year- end shopping frenzy numbers to come.

    Falling energy prices will give an additional lift. The average price for a gallon of regular gasoline in some states has dropped to US$2.65, down 33 cents from a month ago. Since the average American household consumes 1,200 gallons a year the impact is substantial. Adam Slater, senior economist at Oxford Economics, believes the recent drop in oil prices, if sustained, could add almost 0.5% to U.S. GDP growth in the coming year.

    Of course, we have had false starts before but this time the strength seems broadly based. Not only has consumer confidence improved, but all-important business investment is picking up. Non-residential building has been growing at 7.1% while equipment spending is up 10.7%. Companies are making long-term commitments and sometime soon the Federal Reserve is going to step in and gradually apply the brakes by raising its overnight Fed Funds rate. We could see a hike during the next few months but my own feeling is Chair Janet Yellen will wait until later in 2015 to see whether employment figures are sustained.

    In Canada, we have a different situation. Until a few weeks ago I thought the Bank of Canada would also increase short-term rates, perhaps in May, even though our growth remains relatively weak. Now, with oil below US$70 a barrel and likely to remain weak, the prospect of a rate increase has faded.
    Finance Minister Joe Oliver’s 2015 forecast of 2.8% GDP growth has been trimmed but still assumes an average oil price of US$81 per barrel. When challenged, Mr. Oliver was flippant and said that “what I lose at the pump I gain in the mall.” That is not going to happen. We depend on oil exports. Capital Economics economist David Madani estimates we could lose $11 billion of exports in 2014 alone, worth 0.6% of GDP because of falling energy prices since June. We need stimulus. Canada may have to cut interest rates, not increase them.

    Here is my forecast for the coming year.

    U.S. rates: Overnight Fed Funds currently 0.10%, by year-end 1.25%; 10-year Treasury Bills currently 2.3%, by year-end 3.5%; and 30-year Treasury Bills currently 3%, by year-end 4%.

    Canadian rates: Overnight Funds currently 1%, by year-end 1%; 10-year Canada bonds currently 2%, by year-end 2.25%; and 30-year Canada bonds now 2.5%, by year-end 2.85%.

    In short, Canadian interest rates are likely to move sideways in 2015, while U.S. rates climb decisively. We have to keep in mind that the Fed will continue to guide markets and historically the Fed has moved its Fund rate three full percentage points in a year when pushing hard. Using that as a yardstick, something like a one-third throttle seems right in the present situation. That would give us an overnight rate of about 1.25% by the end of 2015 and 2% or more by December 2016.

    As far as Canadian income investors are concerned, bonds are going to remain unattractive. Even long term corporate yields currently in the 4.5% range provide insufficient income for most people’s needs. My suggestion, therefore, is staying with high quality preferred shares and real estate investment trusts (REITs) in the coming year. Use the yield on two-year GICs as a guide but keep in mind these certificates come with strings. Your money is essentially locked-in by call features carrying severe penalties. For example, Scotiabank is offering 2% on its 24-month GIC. If you cash it in though, the rate is far less. As a matter of fact there is no interest paid on redemptions during the first 30 days. Highly liquid RioCan REIT trading at $27.30 and paying a reliable $1.41 distribution to yield 5.2% is a much better bet if you can assume a modicum of risk.

    Having said that, there is some light at the end of the tunnel for Canadian investors who prefer to hold at least some bonds in their portfolios. I think once oil prices stabilize, perhaps by the third quarter, the Bank of Canada will be in a hurry to raise rates if only to protect our shrinking loonie. Higher yields are in the offing even though they will not be apparent until early 2016. Therefore, it’s time therefore for bondholders to start adjusting their holdings to prepare for the change. Here are some suggestions.

    Start by shortening term. The worst place to be when rates are rising is in long bonds with low coupons. They drop significantly in value because the small current cash flow provides little cushion. Conversely a two- or three-year bond with a substantial coupon rate will move hardly at all. At the same time adjust your bond ladder, a strategy whereby some bonds mature each year over a five year span in order to provide continuing liquidity and allow reinvestment of maturing capital at hopefully better rates. Shorten the span to four or even three years.

    Avoid good-quality floating rate securities for now. They are an obvious option but their current yields are extremely low. For example, Power Financial A Floating Rate Preferred Shares (PWF.PR.A) are trading at $19.60 and paying a $0.53 dividend to yield 2.7%. Distributions are linked to the Canadian Prime Rate, which is expected to remain virtually unchanged for most of 2015. Even if there is an upward adjustment, investors will have to wait as much as another quarter until Power’s directors declare the next dividend.

    Look at relatively short blue chip corporate bonds. We are starting to see a yield spread between these issues and government securities. Also opt for higher coupons so that there is downside protection. For a good example, see my Top Pick in this issue.

     

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    DECEMBER’S TOP PICK

    Here is our Top Pick for this month. Prices are as of the close of trading on Monday, Dec. 15 unless otherwise indicated.

    Canadian Pacific Railway 6.25% Medium Term Notes Maturing June 1, 2018

    Type: Guaranteed notes
    Recent price: $112
    Entry level: Current price
    Yield to maturity: 2.08%
    Credit rating: S&P: BBB Conservative, DBRS: BBB (High)
    Risk rating: Conservative
    Recommended by: Tom Slee

    The business: Canadian Pacific Railway, a Canadian icon, was founded in 1881 and spun off from Canadian Pacific Limited in 2001. It owns and operates rail and freight transportation services over a 14,400-mile network linking more than 1,100 communities extending from Montreal to Vancouver and through the U.S. Midwest and Northeast. Market capital exceeds $39 billion and expected revenues of $6.7 billion this year should generate an operating profit in the $2.8 billion range.

    The security: The 6.25% Notes are direct obligations of Canadian Pacific Railway and mature on June 1, 2018. CPR can call these notes at any time at a price that provides a yield equal to the current return on five-year Canada bonds plus 65 basis points. At the present time, with five-year Canada issues paying 1.43%, the redemption price is approximately $121.

    Why we like it: With positive changes at CPR now well underway, these notes are essentially investment-grade caliber, yet they yield about 140 basis points more than most top quality corporate bonds. In addition, they are relatively short term and the 6.25% coupon provides protection against a large unrealized loss in the unlikely event medium-term interest rates start moving sharply higher.

    Credit rating: The notes are rated BBB (High) by Dominion Bond Rating Service (DBRS) and BBB by Standard & Poor’s. Moody’s has a Baa2 rating on the issue.

    Risks: A substantial, prolonged economic downturn could impact the company’s ability to service this debt. This is extremely unlikely.

    Distribution policy: Interest payments of $31.25 per $1,000 face value are made on June 1 and Dec. 1 each year.

    Tax implications: The interest payments are taxable in the year received for Canadian investors who hold the notes outside a registered plan. Any profit or loss from sale, redemption or maturity is taxed as a capital gain or loss in the year when the notes are disposed.

    Who it’s for: The CPR 2018 Notes are suitable for investors who need secure income and guaranteed return of capital as well as an above average return.

    How to buy: The notes are thinly traded in the Canadian corporate bond market. Set a limit and if necessary wait for your fill.

    Action now: Buy at $112. – T.S.

     

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    GAVIN GRAHAM’S UPDATES

    Oil prices are still struggling to find a bottom. Every day brings a new low, with the price of West Texas Intermediate (WTI) crude falling to below $54 on Dec. 16 (figures in U.S. dollars). Brent crude, the international benchmark, was under $60. Prices have been falling for more than five months, as Brent was trading as high as $115 a barrel as late as June this year.

    The sharp decline was driven by a bearish forecast on Dec. 5 by Morgan Stanley analyst Adam Longson. He slashed his 2015 forecast for Brent crude by $28 a barrel (30%) to $70 from $98, with the possibility of oil prices dropping as low as $43 a barrel at some stage during the year. “Without OPEC (Organization of Petroleum Exporting Countries) intervention, markets risk becoming unbalanced, with peak oversupply likely in the second quarter of 2015,” Mr. Longson wrote.

    So far, notes the Globe and Mail, there seems little chance of intervention, after OPEC declined to cut production at its meeting in Vienna on Nov. 27, since when oil prices slumped by more than $12 a barrel (15%).

    The rout was reinforced by comments by the CEO of OPEC member Kuwait’s national oil company, who remarked that oil prices were likely to stay around $65 a barrel for the next six to seven months, another sign that the low cost Persian Gulf producers such as swing producer Saudi Arabia, Kuwait, the United Arab Emirates and Iraq are quite content to have a period of lower prices. With oil down over 40% since June, the established producers are clearly prepared to endure lower prices for a prolonged period. They can afford to do so, with their production costs averaging below $50 a barrel.

    The situation is much more serious for higher cost producers such as Russia and OPEC members Venezuela and Iran, where oil and gas revenues are responsible for over 75% of government revenues. The collapse of the ruble and Venezuelan bolivar over the last few months has been much worse than that of other emerging market currencies that are not so dependent upon energy revenues.

    Of course, this has meant serious consequences for North American oil and gas companies. Some commentators believe that the refusal by OPEC to cut oil production and allow the oil price to slide is a tactic designed to counteract the threat to their revenues from the growth of U.S. shale oil and gas production, which has resulted in the U.S. becoming an energy exporter for the first time since the early 1970s. As many shale oil fields are relatively high cost to drill and their production declines fairly sharply, with over half the reserves in a typical field extracted within two years, there has always been a concern about their sustainability in the long term.

    Should oil prices remain in the $65 to $75 a barrel range for any length of time, much of the anticipated growth in production will become loss making and end up not being drilled. This would both affect U.S. GDP growth and its trade balance, which has been recovering sharply as domestic oil and gas production has replaced imports, including those from Canada. For the moment, the U.S. dollar has been riding high, up 12% on a trade-weighted basis since May and nearing the level, which would represent a breakout from a 25-year downward trend.

    This has helped keep the price of imports subdued and inflation under control, and has acted as an effective tightening measure, relieving the U.S. Federal Reserve from the necessity of raising interest rates any time soon, even though unemployment keeps falling and U.S. wage growth is finally picking up. Falling gasoline prices, of course, are an effective tax break for consumers, and in states with low gas taxes such as Oklahoma, a gallon of premium gas touched $2 this week, a level not seen since the late 1990s.

    Not surprisingly, this all meant an awful performance for energy stocks, and other commodity producers as well. On Dec. 15, the S&P/TSX Composite fell 3.1%, led by the S&P/TSX Capped Energy Index, which fell an amazing 7.2%, the most since August 2011, as crude dropped to a five-year low. At that point, the TSX Composite had dropped 11.4% since hitting a five-year high at the beginning of September, wiping about C$300 billion off the value of stocks and dropping its return for the year to only 0.6%. Having been the second best performing developed market through the end of June, Canada now ranks only 16th, driven down by energy, off 30% year-to-date and materials, off 10%.

    With the banks being hit by lower-than-forecast earnings growth when they reported at the beginning of December, the financial sector has slid 5.8% since November, leaving them only up 4% for the year. As energy, materials and financials account for two-thirds of the TSX Composite’s market capitalization, it will be hard for the index to make headway until the fall in commodity prices stops, especially as the banks’ bad debts due to their energy exposure and related sectors such as oil services, housing and transport in the western provinces will doubtless increase.

    Canadian GDP growth, already slowing from 3.6% in the second quarter to 2.8% in the third, will also be hit. The 10,700 increase in unemployment, with the rate rising to 6.6% in November, may be a precursor of the slowdown. However the weaker loonie, off about 10% against the U.S. dollar this year, may help counteract some of the negative effects by making Canadian exports cheaper and more competitive.

    Lastly, energy companies are responding by slashing their capital expenditures, thus leading to further weakness in business investment. ConocoPhillips, the U.S. oil major, reduced its 2015 capital expenditure budget by 20% to $13.5 billion while Precision Drilling, Canada’s largest oils services company, virtually halved its 2015 budget to $493 million from $885 million this year.

    Let’s see how this dramatic change in oil prices has affected my oil exploration and production recommendations.

    Canadian Oil Sands (TSX: COS, OTC: COSWF)

    Type: Common stock
    Trading symbols: COS, COSWF
    Exchanges: TSX, OTCQX
    Current price: C$8.60, US$7.39
    Originally recommended: Mar. 23/05 at C$16.85
    Annual payout: $0.80
    Yield: 9.3%
    Risk Rating: Moderate risk
    Recommended by: Gavin Graham
    Website: www.cdnoilsands.com

    Comments: On Dec. 4, Canadian Oil Sands announced a 42% reduction in its dividend from $0.35 a quarter to $0.20 when it announced its 2015 production forecast. This caused the stock to plunge to a 10-year low of just under $11. It’s fallen more since then.

    CEO Ryan Kubik forecast production from Syncrude to be between 95 million to 110 million barrels, up from the lower end of the 2014 production of 95 to 100 million, but with an average oil price of $75 a barrel in 2015. Capital expenditure would fall from $1.1 billion to $564 million as major spending projects wrap up. But operating expenditure would be higher at $1.7 billion against $1.6 billion, equal to $45.69 a barrel. This would mean that debt for Canadian Oil Sands would rise to over $2 billion, the top end of the desired range. Therefore, the company decided to cut in the dividend. This should mean that the free cash flow of $730 million ($1.51 per share) in 2015 is sufficient to produce a payout ratio of less than 60%.

    Canadian Oil Sands has always made it clear that the dividend level was dependent upon the price of oil. With the recent sharp fall, it has been conservative in setting its payout ratio. It did so when it reduced its dividend back in 2008-09 and subsequently increased the dividend back up to $0.35 a quarter. However, the present sell-off in the share price, a fall of 60% in six months more than reflects all the bad news.

    Action now: Unless investors want to realize tax losses this year, Hold until the price of oil has stabilized, at which point we will revisit. – G.G.

    Talisman Energy (TSX, NYSE: TLM)

    Type: Common stock
    Trading symbols: TLM
    Exchanges: TSX, NYSE
    Current price: C$5.97, US$5.12
    Originally recommended: Jul. 31/14 at C$11.72
    Annual payout: US$0.27
    Yield: 4.5%
    Risk Rating: Higher risk
    Recommended by: Gavin Graham
    Website: www.talisman-energy.com

    Comments: I recommended Talisman four months ago because the ex BP Canada operation was a cheap, underperforming exploration and production company that was being turned around by former TransCanada CEO Hal Kvisle. The stock has since fallen by more than half, an astonishing collapse for a company, which is still cash generative and now has a suitor in the form of Repsol, a Spanish state controlled oil company.

    On Dec. 15, Repsol agreed to buy Talisman for $9.33 a share, equivalent to US$8.3 billion. While this is a 60% premium to the weighted average price over the last 30 days, it is still 25% below my original recommendation, a sign of how rapid and severe the decline has been with oil stocks. This compares with an average premium of 38% for similar-sized targets in the sector over the last three years. Holders should accept the offer, unless they wish to realize a tax loss this year by selling in the market.

    Repsol is flush with cash after finally receiving the proceeds of its nationalized Argentinean subsidiary YPF this spring.

    As I mentioned back in July, one of the drags on Talisman has been its underperforming North Sea assets, where its 50/50 joint venture with China Petroleum Corp when it sold a half share in its assets in 2012 requires it to spend US$2.5 billion over five years. The market is expecting these assets to be written down before year-end, together with other Talisman assets in the Norwegian North Sea and Kurdistan.

    Nonetheless, selling at less than half its book value and 0.8 times its 2014 sales, Talisman’s share price reflects all of the bad news and much more. The company has completed US$2 billion of sales in 2012-13, has a strong balance sheet (under 55% net debt/equity at end Q3 2014) and investment grade status, and $2 billion of cash flow in 2014.

    Action now: Hold. Talisman will be very volatile until the deal closes and it may yet fall apart. Investors willing to buy Talisman and put up with the volatility of a takeover will make over 50% at the present price of $5.97 if the deal goes through. – G.G.

     

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    DECEMBER UPDATES

    Here are the updates for this month. Prices are as of the close of trading on Monday, Dec. 15, unless otherwise stated.

    National Bank Financial (TSX: NA)

    Type: Common stock
    Trading symbols: NA, NTIOF
    Exchanges: TSX, Pink Sheets
    Current price: C$45.83, US$39.70
    Originally recommended: Mar. 22/06 at C$63.69, US$55.44
    Annual payout: $2
    Yield: 4.4%
    Risk Rating: Conservative
    Recommended by: Tom Slee
    Website: www.bnc.ca

    Comments: National Bank reported unexciting 2014 fourth-quarter earnings of $1.14 a share, in line with expectations, and $4.31 for the fiscal year. The numbers were a mixed bag. Profit of its wealth management division jumped 29% year over year but all-important commercial and residential loans were up only 7%. As a result, the bank is on track to earn about $4.65 a share in the coming year.

    National has worked out very well for us and trades at $45.83, a 44% gain from our recommendation at $31.80. Canadian banks, however, are entering a difficult period as lower commodity prices impact corporate lending and domestic retail business slows. Their stocks are likely to move sideways for a while. Therefore, while NA remains an excellent bank I think we should take our profits at this stage and use the money better elsewhere.

    Action now: Sell. – T.S.

    Freehold Royalties (TSX: FRU, OTC: FRHLF)

    Type: Common stock
    Trading symbols: FRU, FRHLF
    Exchange: TSX, Pink Sheets
    Current price: C$17.27, US$14.87
    Originally recommended: Feb. 22/12 at C$20.37, US$20.51
    Annual payout: $1.68
    Yield: 9.7%
    Risk Rating: Higher risk
    Recommended by: Gordon Pape
    Website: www.freeholdroyalties.com

    Comments: Freehold didn’t escape the energy sector meltdown but the damage was less due to the nature of the business. Freehold is a primarily a royalty company, which means it doesn’t have the high capital expenses of exploration and production firms.

    That doesn’t mean it is immune to a drop in oil prices, of course, but the effect is somewhat more muted, which explains why the stock has held up better than most.

    The company has not made any announcement about its dividend, which currently stands at $0.14 per month ($1.68 per year) to yield 9.7% at the current price. However, a cut at some point cannot be ruled out. RBC Capital Markets said in a mid-November analysis that the dividend looked stable at a WTI price of US$86.50, with a 2015 payout ratio of around 90%. However, the oil price is now well below that level and may not yet have hit bottom. Freehold’s board of directors will have to make some tough decisions early in the New Year.

    In the meantime, the company has been actively making new deals, with a total value of almost $50 million. In the largest one, Freehold will take over most of the assets of Anderson Energy Ltd., which the company says are expected to contribute 350 barrels of oil equivalent per day (boe/d) of mostly working interest natural gas production to Freehold’s 2015 production. Cost to Freehold is $35 million. The other three deals, one joint venture and two royalty arrangements, will add another 400 boe/d.

    Action now: The stock becomes a Hold while we wait for the oil price to settle and for a dividend decision. – G.P.

    Keyera Corp.

    Type: Common stock
    Trading symbols: KEY, KEYUF
    Exchanges: TSX, Grey Market
    Current price: C$69.70, US$60.37
    Originally recommended: July 22/04 at C$12.05
    Annual payout: $2.58
    Yield: 3.7%
    Risk Rating: Higher risk
    Recommended by: Gordon Pape
    Website: www.keyera.com

    Comments: A month ago, Keyera shares were trading at over $90. Now they have fallen to less than $70. Obviously, the stock was another casualty of the fall in the price of oil but in this case the sell-off seems to have been overdone. The company is primarily in the natural gas and natural gas liquids (NGL) business. It’s a midstream operator, providing such services as gathering, processing, fractionation, storage, transportation and marketing. It does not do any exploration or production.

    The company is having a great financial year. Third-quarter earnings came in at $82.4 million ($0.98 per share), more than double the $40.8 million ($0.52 per share) reported in the same period of 2013. Distributable cash flow was a record $124.4 million ($1.48 per share) compared to $50.5 million ($0.64 per share) recorded in the third quarter of 2013. That provides a healthy cushion for the monthly dividend of $0.215 per share ($2.58 per year). That doesn’t mean Keyera shareholders are immune from a dividend cut but based on this year’s financials and the company’s limited exposure to oil prices it seems unlikely.

    When I last updated this stock in June it was yielding 3.3%. That had dropped to 2.6% when the shares hit an all-time high of $99.84 in early September. However, the pullback in the stock price has pushed the yield back up to a more attractive 3.7%.

    Action now: Buy under $65. I think the stock has already sold off too much but if it falls to below $65, the yield will be up to 4%. At that level, it’s hard to resist. – G.P.

    Inter Pipeline (TSX: IPL, OTC: IPPLF)

    Type: Common stock
    Trading symbols: IPL, IPPLF
    Exchange: TSX, Grey Market
    Current price: C$29.02, US$25.14
    Originally recommended: Oct. 21/09 at C$9.99, US$9.62
    Annual payout: $1.47
    Yield: 5.1%
    Risk Rating: Moderate risk
    Recommended by: Gordon Pape
    Website: www.interpipeline.com

    Comments: Any company associated with the energy sector is being punished these days, even innocent bystanders. Inter Pipeline, which has been so good to us since I recommended it in 2009, comes close to falling into that category. The share price has dropped about $10 since its September high of $38.95, with most of the retreat occurring in the last three weeks. This happened despite the fact the company announced a record dividend increase of 14% in early November, bringing the monthly payment to $0.1225 per share ($1.47 annually). That’s up from $0.1075 per month ($1.29 a year). Based on the current price, the enhanced dividend provides a juicy yield of 5.1%.

    CEO Christian Bayle described the increase as “clear evidence that our business has never been stronger. So far this year, Inter Pipeline has commissioned $1.2 billion of new pipeline assets, with a further $1.8 billion targeted to enter full commercial service in early 2015.”

    It appears some investors are concerned that Inter’s pipeline volume could be negatively affected by the oil price decline, resulting in reduced revenue. The company operates about 6,400 kilometres of petroleum pipelines and 4.8 million barrels of storage in Western Canada. Much of the throughput is oil sands production, which amounted to 942,300 barrels per day in the third quarter. It’s the largest segment of the company’s business, generating $82.5 million in funds from operations, or about 59% of the total. So there is some vulnerability if oil sands output should diminish due to low prices.

    However, I see this risk as minimal. Inter has firm contracts with major producers and is investing $3.1 billion to expand its oil sands transportation infrastructure.

    Action now: The stock is a Buy for more aggressive investors who are prepared to assume some risk in a volatile market. Otherwise, Hold. – G.P.

    Pembina Pipeline Corp. (TSX: PPL, NYSE: PBA)

    Type: Common stock
    Trading symbols: PPL, PBA
    Exchanges: TSX, NYSE
    Current price: C$36.83, US$31.90
    Originally recommended: June 24/09 at C$14.77
    Annual payout: $1.74
    Yield: 4.7%
    Risk Rating: Moderate risk
    Recommended by: Gordon Pape
    Website: www.pembina.com

    Comments: Pembina has also experienced a drop in its share price, from an all-time high of $53.04 in September to the current level of $36.83. That’s a retreat of about 15%, which is nowhere near as severe as the pullback in the shares of Inter Pipeline.

    The reason is that Pembina has less exposure to the oil sands. Net operating revenue from oil sands and heavy oil in the third quarter was $52 million or less than 15% of total operating income. The company’s midstream operations ($139 million) and conventional pipelines ($128 million) account for the lion’s share of the income.

    Third-quarter net income came in at $75 million ($0.20 per share). In dollar terms that was up from $72 million last year but on a per share basis earnings were down two cents. For the first nine months of the fiscal year, the company reported earnings of $299 million ($0.85 per share), up from $256 million ($0.83 per share) last year. Adjusted cash flow from operating activities was $613 million ($1.90 per share) compared to $540 million ($1.77 a share) in 2013. The dividend payout was $1.29 per share for a payout ratio of 68%.

    I do not see any immediate concern about the dividend, which is currently $0.145 per month ($1.74 annually). Because of the retreat in the share price, the current yield is 4.7%.

    Action now: Hold. The pullback in the share price is not enough to push this into the Buy column just yet. – G.P.

    Return to the table of contents…

    TOM SLEE, DEANNE GAGE MOVE ON

    As those who subscribe to our companion Internet Wealth Builder newsletter already know, contributing editor Tom Slee is retiring as of Dec. 31. Tom has been a mainstay of this newsletter almost from the time it was launched and his expertise on fixed-income securities will be missed. I’m sure all our readers join me in thanking him for his contributions and in wishing him many happy and healthy years in retirement.

    We are also saying good-bye to associate editor Deanne Gage, who is leaving the position to spend more time with her family. Readers may not be familiar with Deanne, who works behind the scenes, but she has been a pillar of strength in helping to pull together every issue and to ensure our editorial content meets the highest standards. We wish her well in her future endeavors.

     

    That’s all for this issue and for 2014. Look for your next Update Edition on Jan. 15. The next regular issue will be published on Jan. 29. Best wishes for the holiday season to all our readers.

    Best regards,
    Gordon Pape