A little over a year ago, on June 2, 2020, I wrote an article suggesting that Canadian investors skip their usual purchase of lottery tickets for the month. Instead, they should invest in a mixed bag of eight oil service stocks which were then trading below a dollar a share. That’s cheaper than a lottery ticket, with the added advantage that any losses could be shared with the government at tax time. I advised against doing additional research because the triple threat facing them was simply not capable of analysis: failure to approve pipelines to transport Canadian oil to export markets, a price war between Saudi Arabia and Russia, and the collapse in demand caused by the COVID pandemic lockdown.
A recent Reuters article, North American Oil Service Firms’ Pricing and Hiring on the Upswing, prompted me to revisit the sector. Needless to say, I wouldn’t be writing about the outcome if it weren’t positive, but there are a number of lessons from a review of the results.
The accompanying table shows the price performance of the eight stocks profiled last June, plus a number of current financial ratios. (Precision Drilling approved a 20-for-1 share consolidation in November, 2020, which changed the year-ago price from 76 cents to $15.20.) Balance sheet strength is measured by the financial leverage multiplier (FLM). This is calculated as total assets divided by common shareholder equity, so a lower number is better.
With an average gain of 171 per cent in a little more than a year, this was obviously a successful speculation, but to be fair, the S&P/TSX Composite is also up 30 per cent over the same time frame, so it was difficult not to make money over the past year. This group also benefited from a move in the price of oil from US$40 to US$70 a barrel and a relaxation of the lockdown, which improved the outlook for travel and fuel consumption.
In looking back with 20/20 hindsight, what can we learn from this adventure?
First, it is essential to adopt a package approach when dealing with unknown unknowns. A year ago none of these stocks was an institutional favourite and analyst reports were cursory at best. Arguments could be made that the larger capitalization names would be the first to recover as they are more liquid, but a contrarian might favour those with the strongest balance sheets. The actual results are all over the map, so do yourself a favour: Do enough research to identify a representative grouping and then let the numbers fall as they may.
Second, and much to my surprise, all of the companies are still in business – even Bri-Chem Corp. , which back then and still today has a qualified “going concern” note from the auditor. Cathedral Energy Services Ltd. chose to issue 12.8 million shares at 25 cents in early 2021, which represented 25-per-cent dilution, but this did not prevent it from delivering the best return over the time period. Lesson No. 2: In spite of this remarkable survivability record, you should still expect to face the occasional 100-per-cent tax loss with this strategy.
Third, I had expected to see more evidence of mergers and takeovers while prices were so depressed. Some of the market caps a year ago were so small they could have been absorbed for petty cash by a bigger company. To date, only McCoy Global Inc. has announced a strategic review. The good news is that any consolidation will now take place in an environment of improving sentiment so the prices will reflect future potential rather than panic selling. Lesson No. 3: Corporate acquisitors are just as nervous as retail investors at market bottoms. Current shareholders may enjoy further upside if consolidation is only just getting under way.
Which brings us to the final point: After a gain of around 170 per cent, should an investor move on or is there value remaining in this sector?
A year ago, these stocks were trading in a range from 7 cents to 61 cents per dollar of net asset value as measured by the price-to-book ratio. Today, the range is 27 cents to $1.02, so distress pricing is no longer available. In addition, with the industry operating at low capacity utilization rates, we should suspect that many of the assets, primarily drilling rigs, are not worth anything like the balance sheet value. Having said that, these companies have made significant cuts to operating expenses and will enjoy dramatic earnings leverage if a sustained recovery takes place. Except for Cathedral Energy Services, all of them have actually improved their financial leverage as measured by the FLM over the past year. It is reasonable to assume that creditors are breathing a little easier and will cut them some slack.
Lastly, these companies may be located in Alberta, but their fortunes are not tied exclusively to Canada. The table column “% Cdn. revenues” shows that even for the smaller companies, a large part of revenues is generated outside the country. If the Canadian dollar continues to appreciate, this may squeeze margins, but on balance, geographic diversification is a positive. With moderate valuations and improving sentiment for the sector, this package of lottery ticket stocks should be retained for additional upside.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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Robert Tattersall