Canadian Energy: An Industry in Transition

By Les Stelmach, Izabel Flis, Mike Richmond, Naveed Sunderji

Franklin Bissett Investment Management

(Sponsor Content)

This is an interesting time for the energy industry. Occasional reflexive selling based on emerging demand or supply concerns has been short-lived. Late last fall (based on January distribution), consuming nations like the United States tried to mitigate higher crude oil prices by releasing volumes from their strategic petroleum reserves to little avail.

More recently, higher rates of COVID infection in some European countries and the emergence of the Omicron variant sparked some selloff in oil prices, but this is likely to be short-lived as the trajectory for global demand approaches pre-COVID levels.

In addition, the ongoing focus on climate change concerns — most recently articulated at the COP26 conference in Glasgow, — has increased pressure on producing nations and companies to limit production. The current lack of a coordinated suite of energy alternatives that can deliver reliably at the necessary scale does little to deter demand. Arguably, this phase of the transition is contributing to higher prices for crude oil and natural gas. Prices for both commodities have supported greater returns and profitability for oil and gas companies, rewarding investors willing to ignore the volatility.

The path to net zero: journey of 1000 steps

While the last 20 years have seen significant improvements in cost-effectivenes and efficiency for renewable technologies, the sobering reality is that they are not yet able to carry the full load of global economic activity. Renewables still generate comparatively less energy than hydrocarbons, are less stable and vulnerable to demand shocks. An aggressive transition to renewables can backfire, as Californians discovered during last summer’s severe heatwave when their heavily renewable-reliant energy supply was unable keep up with the increased demand. The result was rolling blackouts.

The infrastructure created to support the extraction, production and transportation of hydrocarbons will not be transformed overnight, but in some cases it will become part of the transition to cleaner energy. Pipelines, for example, are essential conduits for hydrocarbons. Political controversy aside, from an environmental perspective they are currently the safest, most efficient, most cost-effective and cleanest mode of transport.

Some natural gas exports are already serving decarbonization efforts in developing nations. In the future, some pipelines may be converted to carry low-carbon recycled natural gas (RNG), hydrogen or carbon dioxide to be sequestered as these alternatives become more widely adopted. Longevity and cash flows for these assets are considered stable over the near future.

Energy and ESG: surprisingly compatible

For oil and gas companies, the emphasis on “E” in ESG (environmental) is really a “C” (climate change). The scrutiny around gas emissions does not isolate one measure to the exclusion of others. Water and waste management, turnover rate, injury rates: these and many other factors are part of a comprehensive ESG analysis.

From an emissions perspective, Canada produces a fairly high-standard barrel. For example, ARC Resources Limited, a longtime holding in Franklin Bissett Dividend Income Fund, is rated triple-A on ESG for a combination of emissions management, water management and governance. ARC was a royalty oil and gas trust for 25 years and has been a producer for the past five years. In that time, they have reduced emissions by 35% while increasing production by 36%, and not just by selling off high-emission assets. Focusing on its operations in northern British Columbia, the company negotiated with BC Hydro to electrify the area, resulting in zero emissions as opposed to using emission-producing generators. ARC also innovates. Because fracking traditionally uses large quantitites of water, they are using MSDI drone-mapping technology to create a closed system to collect and reuse the water.

Companies now in better financial shape

After seven years of mostly hard times, free cash flows for companies in the energy sector are significantly higher. The excess is generally going to dividends, with some capital being raised. They are also seeing some share buybacks, but debt repayment is the more consistent theme and companies are less reliant on banks for financing. Although there is more money to spend, labour shortages and limited capital expenditures impose constraints.

Energy prices are influenced by inflation, and rising costs are keeping companies in line. Investors worried about inflation might want to consider royalty producers, where they earn a percentage of production and can benefit in a rising inflation environment. Franklin Bissett Dividend Income Fund holds Topaz Energy Corp. and Freehold Royalties Ltd., while Franklin Bissett Canadian Equity Fund holds PrairieSky Royalty Ltd., another excellent company.

Small-cap energy companies have been strong performers in 2021. The S&P/TSX Small Cap Index is up 30% year to date and the energy sector, which comprises less than one-quarter of the index, has driven more than half of those returns. The top three positions in Franklin Bissett Small Cap Fund are energy holdings; Trican Well Service Ltd., Headwater Exploration Inc. and Storm Resources Ltd. comprise 10% of assets.

The fund entered the third quarter slightly above market weight in energy exposure, and by quarter-end it had surpassed industrials given the industry’s strong returns. When determining commodity valuations in the fund, we model on the 12-month forward strip. Valuations have contracted, but we are still seeing some great opportunities in good quality companies.

Energy bonds looking good

Demand shocks, labour shortages and the persistence of COVID-19-related disruptions have compounded with higher energy outputs, resulting in inflation and demand destruction. For example, higher gas prices for transporting potash have led to fertilizer plant shutdowns, causing shortages which in turn have led to higher food prices.

But for fixed-income investors, there is a bright side. If higher inflation continues in 2022, interest rates on corporate bonds will also rise. Less interest-rate-sensitive bonds should outperform, as they will have more carry to offset the impact of rising rates. Leveraged loans will be less exposed because of their floating rate structure and high-yield bonds should also do well. As investors become more concerned about the impact of higher costs on their profit margins, that will affect spreads. We see energy bonds outperforming because higher commodity prices can better absorb these inflationary shocks.

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Franklin Bissett Investment Management, a part of Franklin Templeton, manages several equity and fixed income mutual funds that invest in securities of companies in the energy sector, including:

• Franklin Bissett Canadian Equity Fund
• Franklin Bissett Dividend Income Fund
• Franklin Bissett Small Cap Fund
• Franklin Bissett Core Plus Bond Fund
• Franklin Bissett Corporate Bond Fund

Les E. Stelmach, CFA is a senior vice president and portfolio manager at Franklin Bissett Investment Management. He is co-manager of Franklin Bissett Energy Corporate Class (2011), Franklin Bissett Canadian Dividend Fund (2012) and Franklin Bissett Dividend Income Fund (2012). Mr. Stelmach’s analyst responsibilities include coverage of the energy sector.

Izabel Flis, CFA, is a vice president, portfolio manager at Franklin Bissett Investment Management. Ms. Flis shares co-lead manager responsibilities of the Franklin ActiveQuant Canadian Fund (2017), Franklin ActiveQuant U.S. Fund (2017), Franklin Liberty Risk Managed Canadian Equity ETF (2017) and Franklin Liberty Core Balanced ETF (since inception). Ms. Flis is also responsible for providing research coverage on the pipelines and infrastructure, retailing, consumer staples, communication services, and utilities sectors.

Mike Richmond, CFA,  is a vice president, portfolio manager at Franklin Bissett Investment Management and has been with the organization since 2013. Mr. Richmond shares co-lead responsibilities of the Franklin Bissett Small Cap Fund (2019). Mr. Richmond’s analyst responsibilities include coverage of mid and large cap companies within the energy services and real estate sectors. He is also responsible for providing research coverage on a broad range of small cap industry sectors. 

Naveed Sunderji, CFA,  is a research analyst for Franklin Templeton. He focuses on the analysis of investment grade and high yield corporate bonds. His primary coverage includes real estate, exploration & production, pipelines, and power generation & gas distribution.

This commentary is for informational purposes only and reflects the analysis and opinions of Franklin Bissett Investment Management as of December 15, 2021. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry, or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation, nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus or fund facts document before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.