Why I’ve finally thrown in the towel on the TSX

Posted by Jeff Rubin on December 10th, 2014 under SmallerWorldTags: , , ,  • 6 Comments

Adherents of index investing in Canada have had a rough month as falling oil prices have inflicted considerable pain on not just the energy sector but the entire Canadian market. After surveying the landscape I’ve finally thrown in the towel on the TSX and switched my investing allegiance south of the border to the less oily S&P 500.

Look back over the last few years and the biggest challenge facing oil sands producers would certainly seem to be the inability to get a major new pipeline project approved that would allow the industry to sell its ever expanding production to new markets. Now, however, falling oil prices are changing the conversation that Big Oil is having with the rest of the country about the need to build more pipeline infrastructure. At today’s oil prices, the expected doubling of oil sands production over the next decade just isn’t in the cards. If oil sands output isn’t going up then where exactly is the impetus to break ground on a new pipeline? Indeed, the more relevant issue facing oil sands investors at the moment isn’t about how production from northern Alberta might be expanded, but whether the industry’s current level of production is sustainable.

When OPEC’s decision to keep output quotas unchanged triggered the current slide in oil prices, energy investors around the world began pointing to any number of conspiracy theories that would explain why the oil cartel wouldn’t move to safeguard prices. Just why anyone would think it’s incumbent on the lowest cost producers in the world, such as Saudi Arabia, to cut production remains unclear.

At current prices, the Saudis are still making a decent margin on every barrel sold. The same can’t be said for producers with higher costs, many of whom will soon be squeezed out of the market. Consider Canada’s oil sands producers. They’re churning out some of the highest cost oil in the world, while at the same time they’re fetching one of the lowest prices for every barrel sold. Light sweet crude from a shallow well in Texas fetches a much better price from refiners than the heavy sludge that’s being delivered from Canada’s oil sands. It’s one of the reasons why the benchmark price of oil sands crude trades at such a considerable discount to the price of West Texas Intermediate.

If oil prices stay at their current levels, North American producers will have to start making choices about whether or not to shut in production. If they don’t, they run the risk of exacerbating the current glut in world oil markets, which would cause oil prices to fall even further. It’s a situation that’s reminiscent of the one faced by the global coal industry, which has had to contend with an equally challenging collapse in commodity prices.

Consider the chart of an exchange traded fund that tracks oil sands players, in this case BlackRock’s iShares Oil Sands ETF. Since hitting a peak prior to the last recession, it’s lost about two-thirds of its value. If oil sands stocks follow the same path as that of fallen stars of the U.S. coal industry, such as Peabody Energy or Arch Coal, their share prices could end up falling by 80 to 90 percent from their highs before the oil market stabilizes at a much lower price level.

That dismal outlook isn’t just a problem for investors who hold Suncor, Cenovus, Imperial Oil, Canadian Natural Resources and the like. Canada’s biggest oil sands players also number among the country’s largest companies of any type. The oil sands is now a large component of Canada’s energy sector, which means it’s also an out-sized part of the entire TSX Composite Index. Indeed, the energy sector is second only to the financial sector in terms of its weighting in the index. That huge imprint on the TSX means that plunging oil prices are a problem for anyone who owns the broad Canadian market.

I can’t imagine that many investors are clamouring to own an oil sands ETF these days, but I do wonder how much more appetite there might be for an ETF that excludes energy names. Such a product would insulate investors from an overweight sector that carries so much downside risk.

Some investors might choose to steer clear of oil sands stocks for environmental or ethical reasons. Personally, I didn’t disinvest from the oil sands to save the world. I did it to save my portfolio.

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  • Tom Lampman

    Small cap oil is just a Ponzi scheme to keep the NA market for oil chugging along until financial reality sets in. My portfolio has them for the cash flow and not growth. Hopefully they stay solvent until they are picked up by one of the bigger fish in the patch. My lettuce still comes from California, and will need fossil fuels to get it here in Canada. The surplus natural gas should keep my house warm until then. Its just my kids and grandkids I worry about. Jeff’s basic premise still holds, however!

  • Putzmeister

    One thing that Jeff has right is that price determines everything

  • Doug

    You, of all people, who predicted cheap oil would run out and prices would go way up are throwing in the towel? Everyday I keep reading “experts” predicting oil prices will say low forever. Not that long ago those “experts” said high oil prices were here to stay. I can read the contrarian signals here, and figure it’s a good time to get exposure to this sector by buying dirt cheap oil ETFs.

  • David MacLeod

    Doug,
    Jeff’s writing has been more nuanced than how you are portraying him. For example, here’s an excerpt from p. 32 of The End of Growth/The Big Flatline:
    “The relationship between oil and economic growth is a two-way street. Buying oil stocks, for example, is always a great idea when crude prices are going up. But when high oil prices trigger a recession that clobbers demand, crude prices come tumbling back down to earth, bringing those same oil stocks along for the ride.
    That’s why the best cure for high oil prices is high oil prices…”

    P. 38:
    “…the only peak that matters is the one determined by what we can afford, not by how much we can drill. Potential oil resources are only meaningful if we have the money to actually pay for the fuel…
    The resources may be there for the taking, but our economies are already telling us we can’t afford the cost.”

  • Doug

    You’re overanalyzing something that’s actually quite simple, namely buy low, sell high.

  • rock

    jeff, what a sky-is-falling-sky-is-falling chicken-little you are.
    go back to the the hen house, and wait to be slottered.