What are the interest rate increases doing to banks?

In the most recent Issue of the Oddball Stocks Newsletter, our guest writer "SomethingClever" (on Twitter) wrote about the effect that the increase in the ten year bond yield has had on banks:

At the end of 2021, all US banks held about $4.3 trillion of AFS securities and $2.1 trillion of HTM securities. The cumulative mark between the fair value and amortized cost on those bonds was negative $9 billion, which equates to a -0.1% mark. As of June 30th however, that mark ballooned to negative $475 billion or -7.3%, with over half of that mark hidden in the HTM bonds.

Now, you may be reading this and thinking to yourself that a 7.3% loss does not sound so bad in the grand scheme of things. In fact, there are plenty of bond funds out there with worse track records this year-to-date. But what is needed to round this picture out is that banks typically run leverage at 10:1, meaning they hold 10% of their assets in equity, and on the left-hand side of the balance sheet securities usually represent anywhere from 20-30% of assets. This means that any loss on a securities portfolio owned by a bank has a 2-3x multiplier on its impact to its equity. Thus, despite the fact that the 10yr yield has yet to even scrape the levels it was at leading up to the global financial crisis (GFC), banks have taken marks that are triggering TCE ratios last seen during the 2008 downturn.

This is something that we have been talking about in the Newsletter for a long time. In our Issue 19 (back in March 2018), we wrote some "Thoughts on Small Banks and Interest Rates":

During last year's (2017) annual report season, we looked at 33 different tiny banks with an average market capitalization of $55 million. Most of these are not SEC filing and many provide their financial statements only to shareholders.

What we found last year was that the small bank stocks had become quite expensive. The 33 banks had a combined market capitalization of $1.8 billion compared with a book value of $1.5 billion – they traded at 1.2 times book value. Another way to look at valuation is earnings: the banks earned a combined $110 million, so they traded at 16 times earnings.

At that earnings multiple the banks were cheaper than the S&P 500 which traded at 25 times. But these banks, which are very small and mostly rural, have different risk-reward characteristics than the S&P 500. From their base of $1.5 billion of book equity, they have levered up over nine-fold to own $14 billion worth of assets. Looking at each of the 33 annual reports revealed that the majority of them have chosen to boost income by buying long duration fixed income securities. It was common for them to have invested multiples of their equity in low yielding government debt with significant duration.

Imagine a bank with twice its equity in ten year treasury bonds. These will fall in value by about 9% if the yield on the ten year treasury increases by 1%. The leverage of owning twice as much ten year bonds as it has in equity magnifies the loss twofold, so book value would fall by 18 percent. Given the six percent average earning yield on the 33 banks that have reported earnings to us so far, this small interest rate move would wipe out three years of earnings. And this does not even consider the diminution in value that the loan portfolio would experience. (Although this would not show up as a loss in the financial statements, since the loans are not revalued higher or lower based on interest rate changes the way trading securities like government bonds are.)

Of course, the rising interest rate scenario we are talking about is no longer purely a hypothetical. The yield on ten year treasuries rose from a low of 1.37% in June 2016 to its current level of 2.85%. It will be very interesting to see what kind of damage this did to the small banks' equity in 2017 annual reports. (Of course, they will still report positive net income, because changes in bond portfolio values hit the balance sheet through Other Comprehensive Income.) [...]

What we see with small bank stocks is that the situation has inverted over the course of the recovery since 2009. In the beginning they were trading at big discounts to book value and the risk-reward tradeoff of their bond investments was much better. Now that bond yields are lower they are leveraging up and buying more. And meanwhile they are trading at a premium to book value.

Our experience with these small banks is that the people running them are the dumb money. When they are so sanguine about interest rate risk that they respond to falling yields by leveraging up a couple more turns to maintain the same interest income, it seems like the final innings of the bond bull market.

It is debatable whether the great bull market in bonds (which started in Autumn 1981) ended two years ago (summer 2020), but what we do know is that the small increase in rates off of the bottom has caused big losses for banks that were heavily invested in bonds. In his guest piece, SomethingClever wrote,

For the first time since 3Q17, and really the first time in earnest in over a decade, there are banks with negative equity capital, which admittedly is a hard thing to conceptualize. As of June 30th, there are 9 bank subsidiaries with negative equity capital. Going back quarterly, the last time there was a bank in this shape was in the third quarter of 2017: Farmers and Merchants State Bank of Argonia. Going back further on a quarterly basis, there have been 197 instances of banks ending the quarter in a negative equity position since 2000. Narrowing this down, it’s really only 151 banks in total because some banks during the crisis were in this position for multiple quarters. Of these 151 banks, 139 no longer exist, either they were acquired or absorbed by FDIC and sold off.

Excluding the 9 banks that ended June 30th of this year with negative equity, only 3 banks out of 142 made it through and still exist independently today. That is an appallingly low base rate of survival, but of course those banks had negative capital because of credit impairments, while this recent crop has negative capital because of “temporary” losses on securities that most expect to be paid in full at maturity.

In addition to the 9 banks with negative equity that were mentioned in the article (all of which were private and not OTC-listed), we also had a list of public banks that lost more than a third of their equity in the first half of 2022. Some of these have probably been pushed into negative equity with the interest rate move during the third quarter, including - almost certainly - Mauch Chunk Trust Financial Corp. (MCHT) in Jim Thorpe, PA. 

This paragraph was in their second quarter of 2022 letter to shareholders:

Total shareholders’ equity capital on June 30, 2022, was $838 thousand, $46.7 million less than 2021. Lower equity capital this year is the result of a $50.5 million increase in accumulated other comprehensive loss associated with the change in the value of the securities portfolio resulting from an increase in the level of interest rates. This decrease was partially offset by an increase in retain earnings of $4 million. MCTFC’s capital remains well above the regulatory minimum requirements to be considered well capitalized.

MCHT is an interesting case study. At the beginning of the year it had $49 million of equity, $624 million of assets, $367 million of securities ($199 million due after 10 years) and a $40 million market cap (0.83x book).

As of June 30th, it had only $838k of equity and a $27 million market cap (33x book). They earned $1.4 million (excluding securities losses) in Q2 so that is under 5 times annualized earnings - assuming that their deposit cost doesn't go up.

Their deposits are almost all interest bearing. Interest expense was $394k in Q1 and rose to $503k in Q2. (Cost of funds 26 bps in Q1 vs 34bps in Q2.)

Interesting to think that with a further increase in funding cost of probably less than a percent, they would no longer be profitable.

Once is Chance, Twice is a Coincidence, Three Times is a Pattern

About nine months ago, Oddball Stocks Newsletter guest writer Catahoula wrote an article entitled “Put Yourself in My Shoes” on Five "Teenage" OTC-listed banks that were trading between 0.75x and 1.25x Tangible Book Value, with an efficiency ratio under 55%, net interest margin greater than 300 basis points, and were between 10 to 20 years old (hence, "teenagers").  

Today, we sat up and took notice when the third of those five banks, Centric Financial Corporation (CFCX) announced a merger with First Commonwealth (FCF) in an all-stock transaction valued at approximately $16.20 per share.

Over the years, we've grown fond of Centric, a solid bank that has flourished under Patti Husic, President and CEO. CFCX  was founded in 2007, making it a teenager at 15 years old. Centric Bank has principal executive offices in Enola, Pennsylvania. This is the Harrisburg area about 110 miles away from Philadelphia. A major hiccup along the way occurred about a year ago when the bank suffered a $5.1 million fraud in 3Q21. Though mighty unpalatable, one loan fraud is a business risk in banking.  

CFCX has sometimes traded 85% of tangible book value, which is confounding. If you compare Centric (CFCX), which trades on OTC, with Bank of the James (BOTJ) a similarly-sized bank on the NASDAQ, Centric is more efficient and profitable. But there's sometimes been a valuation difference of thirty percent of tangible book value between otherwise comparable public and private (OTC-listed) banks! 

We find this really fascinating because these paired comparisons of similarly-sized banks demonstrate a discount that arises purely by virtue of being OTC-listed instead of public. If the Oddball Stocks Newsletter stands for anything, it is for harvesting this OTC valuation discount.

We asked Catahoula why he thought that so many of the teenage banks he mentioned have merged.  He said that a bank in its second decade often faces increasing pressures. The board and executives have tapped out their contacts in the immediate community for business. They contemplate growth through expansion, but they are not as familiar with neighboring towns. Sometimes they are reluctant to acquire acquire another bank. He also said that capital management becomes more important. As profits accumulate, banks may face pressure to pay a dividend or buyback stock.

Often, early investors look for a a cash-out of their initial investment before two decades have elapsed.  Banks initially listed on the OTC Markets usually intend to graduate to the major exchanges, hoping to uplist to NASDAQ, and ultimately the NYSE. Uplisting supports expansion of the shareholder base to include institutional investors, with a goal of eventually becoming included in the Russell 2000 or 3000 indexes.  

Whether increased valuation comes from a buyout or uplisting to a major exchange, at Oddball Stocks we like to eat steak for the price of hamburger. We will continue to bring you small, non-public companies and banks trading in the obscure corners of the market. If you are interested in the two remaining teenage banks that Catahoula identified, be sure to check out Issue 37 of the Oddball Stocks Newsletter.

Just Published: Issue 41 of the Oddball Stocks Newsletter

We just published Issue 41 of the Oddball Stocks Newsletter. If you are a subscriber, it should be in your inbox right now. If not, you can sign up right here.

Remember that we have made some back Issues of the Newsletter available à la carte, so you can try those before you sign up for a subscription. 

The past two years' back Issues are available for $139 per copy. (Links for purchase: Issues 32, 33, 34, 35, 36, 37, 38, 39, and 40.)

Our older Issues (19-31) are available for $99 per copy. (Links for purchase: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, and 31.)

We also published a Highlights Issue in February 2020. The Highlights Issue is available here for purchase for only $59 as a single Issue. If you have been curious about the Newsletter, the Highlights Issue is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

Also, we tweet regularly from the @stocksoddball account on Twitter so be sure to follow us there.

Second of Catahoula's Five "Teenage" Banks Acquired

In November 2021, our guest writer Catahoula wrote a guest piece in the Oddball Stocks Newsletter entitled: Guest Piece: “Put Yourself in My Shoes” by “Catahoula” on Five Teenage OTC Banks. (That Issue #37 of the Newsletter is available à la carte.) He writes in with an update,


In February, Peak Financial in Idaho (IDFB) got taken out. Last week, Integrated Financial Holdings (IFHI) announced a nice merger. MVBF is tech-forward and fintech-sensitive. It's an all-stock acquisition, so I might consider hanging around. IFHI built a nice platform for government guaranteed loans at West Town Bank. 

From my November 2021 article in Issue 37, there are three remaining teenage banks -- CFCX, USMT and CMRB. In 2Q22, CMRB's operating results continued to flag due to increased salary and bonus expenses. As "Ronbo" on Twitter summarized: 

All of the long-time holders (myself included) were unhappy about the deterioration in the operating results. I sold out my full position. As "Our Bank" on Twitter said: 

Although I no longer have a dog in this hunt, if CMRB can't find its footing, in my opinion it will be increasingly vulnerable to acquisition. The board owns ~20% and former CEO Herb Schnieder had 2.5% or so (the last proxy before he departed). As I mentioned in the article:

"When I look at the opportunity set among OTC banks, I identified five that have reached their second decade. I believe they are either set on a path to acquisition or a profitable long-term niche."


Be sure to check out Issue 37 of the Oddball Stocks Newsletter and read Catahoula's piece on the three remaining "teenage" banks.

Pardee Resources Co. ($PDER) Reports Q2 2022 Results

Pardee Resources Co. (PDER) published quarterly results (PDF) for the period ended June 30th.
During Q2 2022, Pardee Resources Company earned $9.24 per share, an increase of 211% above the $2.97 per share earned during Q2 2021. EBITDA during the quarter was $14.74 per share, 144% higher than EBITDA of $6.03 earned in 2021. Supported by strong commodity prices during the quarter, our Metallurgical Coal, Timber & Surface, and Oil & Gas Divisions achieved meaningful revenue improvements over Q2 2021 results. Quarterly revenues from our Alternative Energy Division were down versus last year due to a decline in both power production and the average realized price of our renewable energy credits. Despite high summer temperatures in both California and Portugal, our table grape and almond crops remain on track for a healthy harvest season.

Metallurgical Coal Division: Strong global coal and steel markets lifted U.S. metallurgical coal markets which were further strengthened by the fallout from the Ukraine War. While new U.S. longwall mines helped to meet demand, a limited supply response from Australia and Canada, together with equipment, labor, and transportation bottlenecks in the U.S., kept global supplies in check. As a result, 2022 domestic High Vol-A metallurgical coal contracts settled at record high prices of over $180 per ton. At Pardee, a year-over-year production increase resulting from a new deep mine, coupled with stronger pricing, led to Q2 2022 Division revenues of $6.3 million, 127% higher than our Q2 2021 results; while first half (H1) 2022 Division revenues totaled $11.0 million, 140% above last year’s results.

Oil & Gas Division: During Q2 2022 natural gas prices continued their upward momentum, but not without significant volatility. LNG exports and limited gas-to-coal switching led Appalachian Basin prices higher, from a monthly average of $3.23 per MMBtu in January to $6.49 per MMBtu in May. Prices then fell from their interim highs after an explosion in early June forced a major U.S. LNG export facility offline, crimping demand and prices. Late in the quarter, prices were trending upward again as a heatwave spread across the U.S. causing a natural gas demand surge from electric power producers. As a result of the strong pricing year-to-date, Pardee’s H1 2022 Division revenues reached $6.6 million, a 101% gain above H1 2021 Division revenues of $3.3 million.

Timber & Surface Division: Strong markets during the quarter sustained hardwood lumber and log prices at elevated levels. Single-family housing starts for the first six months of the year were up 8% over the prior year period, while home remodeling expenditures increased 18%. Hardwood lumber exports through May were also up 21% in dollar value versus the prior year. During Q2 2022, Pardee’s realized average hardwood stumpage price was $374 per mbf, 21% higher than Q2 2021 levels. Meanwhile, our Q2 2022 hardwood production was down versus last year due to harvest timing variances, while H1 production year-over-year was flat as logging operations remained challenged by shortages of labor, equipment, and trucking services. Quarterly gains from our Virginia rural real estate initiatives were $394,207, bringing the total for the first half of the year to $1.3 million.

Alternative Energy Division: While high prices for oil, natural gas, and coal placed renewed urgency to develop solar generating capacity, U.S. installations during Q1 2022, which is the latest data available, were 21% lower than Q1 2021 and 52% lower than Q4 2021. The reduction in U.S. solar installations was due to a Department of Commerce tariff related investigation which halted solar module shipments to the U.S. from Asia, a constraint which is expected to remain through the end of 2022. Electricity production from Pardee’s renewable portfolio during Q2 2022 was 15.3% lower than during Q2 2021, due to both year-over-year weather variances and equipment-related outages. Meanwhile, our average SREC price dropped 17.5% versus Q2 2021, following the expiration of certain long-term contracts in New Jersey. Overall, quarterly Division revenues were $992,000, a 23% decline versus our Q2 2021 results.

Agriculture Division: Despite the high summer temperatures recorded in both California and Portugal during Q2 2022, our table grapes and almond trees are developing well, and healthy harvests are expected in the fall. In California, our table grapes benefited from warm days and cool nights; while in Portugal, the plentiful water supplies allowed for irrigation sufficient to avoid the negative effects of hot weather. As reported in our Q1 2022 Report, we do not expect the current drought in the U.S. West to materially impact our table grape operations since both of our ranches have access to sufficient well water.

Recently, we got to thinking about how Pardee's timber acreage per share has changed over time.  At the end of 2002, Pardee had 770,196 shares outstanding. They had not yet bought their 44,000 acre “Powellton” timber tract in West Virginia (for which they paid $18 million in 2003), so their timber holdings must have been about 156,000 acres, or 0.2 acres per share. It also had a book value of $36 million, paid a total of $1.78 in dividends that year, and had $4.7 million of outstanding preferred stock at liquidation value. The shares traded for about 1.5x book value. 

As of the second quarter of 2021, Pardee had 660,112 shares outstanding and owns something on the order of 155,000 acres of land. Their holdings have grown to 0.24 acre per share, or a 20% increase in acreage per share, during a period of 20 years – thanks to share buybacks. Meanwhile, Pardee's book value increased by 4.3x to $155 million, it returned $15.4 million to shareholders in 2021, and it currently trades for 1.1 times book value.

If you are interested in Pardee, you will find the June 2022 edition (Issue 40) of the Newsletter especially worthwhile. Guest writer Marcus Frampton's piece was titled, “Pardee Resources vs. Beaver Coal – a Comparison of Two High-Yielding, Coal-Rich Land Companies”. The Issue is available here for purchase à la carte.

Previously, regarding Pardee Resources on the blog:

We will have more about Pardee Resources in the upcoming August 2022 edition of the Oddball Stocks Newsletter, which will be our 41st Issue.

"The Family Behind Pinelawn Memorial Park Cashed in During COVID"

Earlier this month we posted an excerpt on the blog from the Oddball Stocks Newsletter about Pinelawn Cemetery. A journalist from ProPublica has just published a long exposé on Pinelawn Memorial Park, which has "land share certificates" that trade on the OTC:

All those new graves and higher prices at Pinelawn translated into cash for the Locke family, the descendents of the cemetery’s founder. The explanation lies in an obscure but lucrative financial instrument called a “land share,” which in Pinelawn’s case dates back to 1904 and pays dividends twice a year. Those payouts more than doubled during the early months of the pandemic, from $13.65 per share in August 2019 to $28 in August 2020, before subsiding to $20.70 in August 2021.

The Locke family owns 51,964 of the 127,850 land shares that were issued by Pinelawn during the presidential administration of Theodore Roosevelt, and which still circulate today. The shares are unusual in another regard: Some of the rest are traded on an over-the-counter Nasdaq market — their price has more than doubled over the past five years — and a small coterie of investors have bought shares, coveting their reliable revenue stream. No other cemetery land shares are listed on Nasdaq’s OTC Markets Group.

Calling them “land shares” is a bit of a misnomer, since they don’t actually entail owning land. Instead, they’re an investment, originally used to fund the creation of the cemetery, that entitles the holder to dividends derived from the sales of cemetery plots. Half of the proceeds from each sale of a plot go to pay the dividends, with the other half used to take care of the property.

The shares remain valid until the last plot is sold and the empty land at Pinelawn has been used up. That day is far off. Of Pinelawn’s 839 acres, more than 600 remain unsold and undeveloped today. In 2018, Pinelawn president Justin Locke said that at the current pace the cemetery wouldn’t run out of land for at least 206 years.

That is much more unsold land than we had previously estimated. However, it seems plausible because Pinelawn has enough undeveloped land that they have proposed to develop warehouses and office buildings on some of it:

Justin Locke was appearing before the Cemetery Board to sound them out on a new idea: leasing 100 acres of Pinelawn’s property to develop into warehouses and office buildings.

Justin Locke made his case to the Cemetery Board, starting with the surprising claim that the area of the cemetery he wanted to develop was blighted. He described the 100-acre parcel as filled with “crime, trespassing, quality-of-life issues that are affecting the neighbors, complaints. It’s hurting our reputation.” (The “crime” he was describing seemed to consist largely of trespassers riding ATVs on the property.)

Noting Pinelawn’s extensive unused land, Locke touted the potential revenues the cemetery could earn by leasing the parcel. He called it a “cake-and-eat-it scenario where we can leave the property over there, maintain control over it, but generate a substantial income off of it in the meantime.”

The Pinelawn certificates are now "expert market" on the OTC. Recently they have been trading in the low $500s, which is about an 8% distribution yield on the most recent two distributions.

Oddball Stocks Newsletter Excerpt - Pinelawn Cemetery (Issue 38)

This is an excerpt from our Company Updates in Oddball Stocks Newsletter Issue 38 (January 2022): 

We recently did a deeper dive on Pinelawn Cemetery and its “purchase money certificates” that trade as PLWN on the OTC and collectively are entitled to “one-half the gross proceeds of the sale of the use of lots in Pinelawn Cemetery.” One thing that we were able to confirm is that there are 127,850 land purchase certificates outstanding. That means that the market capitalization of these interests, in total, is $67 million at $525 per share. We have a list of certificate shareholders that, while not current, shows that members of the Locke family, which control the cemetery nonprofit, owned something like 30,000 of the certificates. Rather than worrying that the cemetery management would want to disadvantage the certificates, it actually appears as though their incentives are aligned with the PLWN holders. In fact, if anything the State of New York has gotten upset that too much was being paid to the certificates.

Our understanding is that in 2004, Pinelawn had half of its 785 acres unsold. It is a bit difficult to tell how much is unsold now, but keep in mind that cemeteries have evolved towards denser ways of sharing the same remaining, limited space. Suppose that Pinelawn had 300 developable acres remaining. That would mean that the current “enterprise value” is $67 million divided by a half-interest in 300 acres, or $450,000 per acre. If you can fit 400 “lots” per acre on 300 acres that would be $1,000 per lot. Since the lots are worth quite a bit more than that, the back of the envelope math is there for the certificates to still be pretty attractive at this price.

Oddball Stocks Newsletter Excerpt - Pardee Resources Company (Issue 38)

This is an excerpt from our Company Updates in Oddball Stocks Newsletter Issue 38 (January 2022): 

At the end of 2021, Pardee declared a nice special dividend of $15 per share, which was in addition to $7.20 of quarterly dividends during the year. (We are waiting by the mailbox to see how much more money Pardee made during the fourth quarter from metallurgical coal royalties.) Thinking about Keweenaw's sale of land, and doing the analysis for the Dorchester Minerals update in this Issue, got us to thinking about how Pardee's timber acreage per share has changed over time.

At the end of 2002, Pardee had 770,196 shares outstanding. They had not yet bought their 44,000 acre “Powellton” timber tract in West Virginia (for which they paid $18 million in 2003), so their timber holdings must have been about 156,000 acres, or 0.2 acres per share. It also had a book value of $36 million, paid a total of $1.78 in dividends that year, and had $4.7 million of outstanding preferred stock at liquidation value. The shares traded for about 1.5x book value.

In the third quarter of 2021, Pardee had 656,993 shares outstanding and owns 161,225 acres of land. Their holdings have grown to a quarter of an acre per share, or about 20% per share increase, during a period of 20 years – thanks to share buybacks. Meanwhile, Pardee's book value increased by 4.3x to $155 million, it paid $22.20 of dividends last year, and trades for only 90% of book value.

Oddball Stocks Newsletter Excerpt - Dorchester Minerals, L.P. (Issue 38)

This is an excerpt from our Company Updates in Oddball Stocks Newsletter Issue 38 (January 2022): 

Dorchester Minearals is a publicly-traded limited partnership that owns producing and non-producing mineral, royalty, overriding royalty, net profits, and leasehold interests in in crude oil and natural gas acreage in multiple basins nationwide.

Dorchester Minerals (DMLP) was mentioned by a participant at the February 2019 Oddball Meetup, in Catahoula's Issue 26 guest piece, “A Report from the Pasture,” his Issue 28 guest piece “Oil and Gas Royalties: Searching for Buried Treasure in the Digital Age,” in our General Commentary about “Value vs Growth” in Issue 35, and in our feature in Issue 37: “Value in 'Dying' Industries.”

While any individual oil and gas well or field depletes over time, Dorchester's production has grown thanks to an ability to make good acquisitions. Sellers of non-operating mineral interests can trade their illiquid landholdings in a non-taxable exchange for partnership interests of Dorchester that are better diversified geographically, more liquid, and which have the potential to grow.

At the end of 2020, when hydrocarbon prices (and therefore estimates of reserves) were lower, Dorchester had 35 million units outstanding and had proved, developed, producing reserves of 9 million barrels of oil and 34 million mcf of natural gas, giving each unit of Dorchester a proportional interest of about a quarter of a barrel of oil and one thousand cubic feet of natural gas. And that was just the resources that were currently developed and producing; there are sure to be plenty of undeveloped hydrocarbons remaining in their 3.7 million gross acres of property.

Something interesting is that oil prices at the end of 2004 were about the same - $50 per barrel – as they were at the end of 2020. Dorchester had fewer units outstanding then (28 million) but had much lower reserves of oil: only 4 million barrels. This means that even though Dorchester has been producing and selling oil for the past 18 years, and issuing new limited partnership units to make acquisitions, its reserves of oil per unit have grown from 0.14 barrels to 0.26 – nearly doubling. Over a 16 year period, oil reserves per unit grew at 4% annually instead of declining, thanks to acquisitions.

Although Dorchester Minerals has not released its annual report for 2021, they did announce that the fourth quarter 2021 cash distribution will be $0.64 per unit. On an annualized basis, this is $2.56 per unit, which is an 11% yield on the current price of $23.50 per unit.

Oddball Stocks Newsletter Excerpt - Canadian Oil Sands (Issue 37)

 This is an excerpt from our Feature article in Oddball Stocks Newsletter Issue 37 (November 2021), "Value in 'Dying' Industries":

One of our theories is that mineral landowners (i.e. energy royalties) and pipelines are the best part of the hydrocarbon value chain. In particular, we shy away from explorers and producers, which have trouble creating as much long term value for shareholders because management's incentives are bad. They get paid to grow asset size, and they only have the money to do that at the top of the cycle when properties are expensive. An exception to this is oil producers with very long reserves. If you have decades worth of oil in the ground, you can focus on producing it instead of trying to outbid other producers for new reserves. The prime examples in this category are the major Canadian oil producers.

Suncor Energy is fully integrated with oil sands, conventional oil production, refining (462k bbl/d), and retail operations. Together, Cenovus and Suncor produce about as much oil (~1.2mm boe/day) as the entire Bakken region in North Dakota, or a smaller OPEC member like Algeria or Angola. The big story with Suncor's business is the upstream (oil sands and conventional) production, which produced almost 700k barrel of oil equivalents per day in the third quarter, of which 600k was from oil sands production. Oil sand is a mixture of bitumen, sand, clay, and water. It does not flow like conventional crude oil which is a liquid; it must be mined or heated underground before it can be processed. Suncor extracts bitumen in two ways: mining and in situ.

About 20% of the oil sand is close enough to the surface (under 200' depth) to be mined. They use large trucks and shovels to extract these, and then use hot water to separate ("extract") the bitumen from the sand. Bitumen is heated and sent to drums where excess carbon (in the form of petroleum coke) is removed. Vapors from the coke drums are sent to fractionators where they condense into naphtha, kerosene and gas oil. The end product is synthetic crude oil, which is shipped to refineries across North America to be further refined into jet fuels, gasoline, and other petroleum products.

The other 80% of oil sands are too deep to be mined with trucks and shovels. This is extracted in situ, using Steam Assisted Gravity Drainage. Horizontal wells inject steam to heat the reservoir of underground oil sands. The heat separates the bitumen and gravity brings it into a lower horizontal well bore which collects it and pipes it to upgrading facilities.

Suncor was founded in 1919 as Sun Company of Canada, a subsidiary of Sun Oil. In 1979, Sun formed Suncor by merging its Canadian refining and retailing interests (Great Canadian Oil Sands) and its conventional oil and gas interests. In 1995 Sun Oil divested its interest in the company and Suncor became an independent public oil company. In 2009, Suncor merged with Petro-Canada, a downstream refiner and retailer. In 2016, Suncor acquired Canadian Oil Sands, which had a 37% ownership stake in a project called Syncrude in Alberta. Together with Suncor's existing 12% ownership of Syncrude and the purchase of Murphy Oil's 5% stake, Suncor became the majority shareholder in the project, which produces 350k bbl/d from the Athabasca Oil sands outside Fort McMurray, Alberta.

Suncor is listed on both the NYSE (SU, US$25) and the Toronto Stock Exchange (SU.TO, CAD$31.67). (As you can see, a CAD$ is equal to 0.79 US$). The market capitalization is $36 billion. (This and other figures in US$.) They have $15 billion of debt at Sept 30 and $1.9 billion in cash for net debt of $13.5 billion and an enterprise value of $49 billion. (Suncor is able to borrow long term very cheaply: their debt due in 2047 yields only 3.2%.)

For the third quarter, Suncor's cash from operations (excluding changes in working capital) was $2.1 billion and its capital expenditures were $990 million, for free cash flow of $1.2 billion. That's just for the quarter: annualized that would be $4.8 billion. They have another metric that they call "discretionary free funds flow," which was $1.2 billion for the quarter as well.

Keep in mind that WTI oil in the third quarter averaged $71 and WCS crude sold at an average $13.6/bbl discount to this. Crude oil is now $10 higher (low $80s) and the differential is about $16/bbl, for a crude oil realization that's about $7.5 higher. The FCF yield on the current enterprise value is 10% at a lower oil price than today. That provides room, even if oil prices were to retrace from here, to pay a 5.6% dividend ($1.36 US on $24.18 share price) and buy back significant amounts of stock, i.e. 4.4% of the market cap annually if the share price and earnings stay at this level. So no wonder they are buying back stock aggressively. You will also notice that in the third quarter they returned 83% of free cash flow to shareholders through dividends and buybacks.

As of December 31, 2020, Suncor had proved and probable (2P) reserves, net of royalties, of 6.7 billion barrels of oil equivalent. This was calculated when oil prices were lower, which would mean that less of the resource was booked as being profitable to extract than may ultimately be extracted. At the present production rate of ~0.7 million barrels of oil equivalent per day, or 255 million barrels per year, those 2P reserves are enough to last for 26 years. And the enterprise value per 2P barrel of oil is $7, a figure about the same as Cenovus. (This also ignores the value of Suncor's refining and marketing operations.) The oil sands business spent $2.2 billion to produce about 54 million barrels of oil during the quarter, which is a production cost of $40 per barrel.

Another Canadian oil producer is Cenovus Energy, listed on the NYSE (CVE, US$12.12) and the Toronto Stock Exchange (CVE.TO, CAD$15.34). The current market capitalization is US$24 billion and the enterprise value is $37 billion. The third quarter's CAD$1.7 billion of free cash flow, which annualizes to CAD$6.8 billion (US$5.4 billion) gives a FCF/EV yield of 15%. Thanks to the leverage and the low cost debt, Cenovus equity is trading at only about 4.4x cash available for distribution. Also impressive is the level of FCF conversion; out of $2.3 billion CAD in adjusted funds flow, $1.7 billion is "free" (in excess of capital expenditure), which is 72%. Management commented on further uses of cash flow in the Q3 conference call:

“We finished the third quarter with net debt of about $11 billion, a reduction of $1.4 billion since the end of the second quarter. And today, we are very close to achieving our interim net debt target of below $10 billion, which takes me to our shareholder returns announcement. We have been clear that increase in shareholder returns would be our first priority, upon reaching our interim net debt target. Delivering on that commitment, our Board has approved doubling the dividend on our common shares effective for the fourth quarter dividend to $0.14 per share. In addition, the Board has approved filing of an NCIB application with the TSX for share buyback program of up to about 150 million common shares, which we expect to commence following the achievement of net debt below 10 billion. We will provide more context on how we think about capital allocation at our virtual investor day on December 8th. However, as we have said previously, when we are below 10 billion net debt, you should expect to see a more balanced approach to free funds flow application between further de-leveraging and shareholder returns. And at current commodity prices, we would expect to be able to execute our buyback plan in 2022, while achieving net debt under eight billion around mid-year.”

Dorchester Minerals, L.P. (DMLP) was mentioned by a participant at the February 2019 Oddball Meetup, and in Catahoula's Issue 26 guest piece, “A Report from the Pasture”. It is a publicly traded partnership that owns royalty, overriding royalty, and net profits interests in crude oil and natural gas acreage in multiple basins nationwide. Unlike exploration and production companies that drill wells, Dorchester has no debt, little capital expenditures, and high margins.

The current market capitalization of Dorchester is $631 million, and year-to-date it has earned $54 million of EBITDA. Free cash flow conversion is extremely high (actually above 100% due to the sale of some properties). The result is that the FCF yield to the enterprise value (annualizing the first three quarters' results) is about 11.9%, but of course this was in a lower oil price environment than what is prevailing now. (Dorchester distributed $48.2 million to limited partners in 2020. Their average selling prices of oil were high $40s/bbl and for natural gas a bit below $2/mcf.)