2016-new-year-goals

Here’s hoping “bezzle” isn’t the word of the year for 2016. It’s not a well-known term and Google notes that its usage last spiked in March 2009, when equity indexes bottomed out during the financial crisis.

While it sounds like a Seussian concoction, the word bezzle was actually coined by famed economist John Kenneth Galbraith to expound upon the 1929 stock market crash.

A bezzle is an increase in the perception of wealth—whereby everyone seems like a winner despite the underlying reality of the situation. It is derived from the word “embezzlement” and describes the period after which someone has been swindled, but before they find out.

During that time, both parties seem to enjoy the wealth—the swindler in actuality, and the victim through ignorance of the truth.

But its meaning can go far beyond describing illicit circumstances. It is used in reference to various asset bubbles, whether it’s Bitcoins in 2013, the U.S. housing market in 2008, the tech craze in 1999, or the stock market in the 1920s.

For instance, the U.S. housing crisis allowed many Americans to borrow money to live beyond their means for years in homes they could never have afforded in saner times. In that instance, the financial institutions were the winners. The temporary winners were the people enjoying their newfound wealth before eventually losing their savings, and having to bail out some financial institutions with their tax dollars to boot.

Fast forward to Canada today, and the current asset bubble is arguably our resource-heavy economy. But, are we still living inside the bezzle period, ignorant of the full wrath that the plunge in energy prices will bring?

Are asset values realistic?

Based on spot energy prices, many of the assets held by energy companies would seem to be uneconomic, and worth a mere fraction of their stated values. It’s been almost a year since we first thought that energy company balance sheets were too frothy, propped up by accounting rules.

This period of psychic wealth continues to linger—though the stock market has arguably done some of the job that executives and auditors won’t, which is to give a haircut to the underlying asset values.

And while the asset bubble of energy prices has undoubtedly deflated, what about the secondary impact of that decline? The other shoe to drop is the expansive impact that the decline in energy prices and the Canadian dollar will have on non-resource businesses.

Those secondary impacts are being felt in the West already, where companies with greater geographic exposure are feeling the pain. It was first seen in auto sales and commercial real estate, and has spread to telecom and other services. The share prices of companies in those sectors have reflected the declines.

Financial stocks, as the direct lenders to energy companies, have shown only some recognition, and the banks readily discuss their sensitivities to direct-energy exposure. But the secondary impact is not yet being quantified.

CIBC, for instance, states that $6 billion, or just 2%, of its loan portfolio has exposure to energy, and much of that still remains investment grade. RBC rates its exposure at a similar 1.6% level.

Stress-tested with oil at $30/barrel, the CIBC portfolio would produce losses of $650 million over three years, which still wouldn’t cause the bank severe pain. Scotiabank says it would experience similar losses, noting the impact would be spread out over several quarters.

Are the banks providing enough detail?

Most bank executives’ compensation (both direct and share-based) is tied to profit and share price, so it’s in their best interest to say that the negative impacts of low energy prices are contained.

In this regard, the vagueness of the accounting rules is still their friend. When it comes to the detailed disclosures that investors would need to assess secondary exposure, the rules don’t require it, and many banks aren’t voluntarily providing it.

In fact, executives are steering the discussion in the other direction, either by downplaying the total impact of energy exposure, or redirecting to potential positive effects or exposure to other countries entirely.

For instance, BMO has stated that energy exposure should only lead to loan losses of 40 basis points on their overall portfolio at most (again, this would seem to ignore secondary exposure). National Bank expects a similar impact of 30 basis points at most.

Further, the CEOs of both TD and RBC have highlighted their exposure to the U.S. and its growing economy. And BMO has pointed out the potential positive impact that the weaker Canadian dollar can have in driving manufacturing and service business back to Canada, especially to the non-resource provinces.

Overall, the current disposition of Canadian bank executives is reminiscent of late 2007 and early 2008, when the disclosures needed by investors started at a mere dribble. It took several quarters before banks started to provide the level of detail needed to allay fears of greater contagion, and to move share prices higher again.

This implies that bank shares have not reached their bottom. Due to the uncertainty that still exists regarding the banks’ overall exposure, advisors might do best to hold off for several more quarters, and wait for the horizon to clear before adding to client positions.

oil production will continue to grow

While the debate rages on regarding the Energy East project, the Montreal Economic Institute (MEI) notes that even in a scenario in which absolutely no new pipelines are built, oil production in Canada will increase significantly from now until 2040, as the National Energy Board (NEB) stipulated in a report.

So, it’s a mistake to believe that systematic opposition to the construction of pipelines will reduce either our production or our consumption of oil in the coming years, as certain commentators imply. “The NEB report is clear: Canadian oil production will continue to grow over the next 24 years, independent of whether the price of oil goes up, or whether pipeline projects go forward,” says Youri Chassin, research director at the MEI.

In the NEB’s reference scenario, the price of oil will reach $80 four years from now, and $105 by 2040. In this case, Canadian production would increase to 6.1 million barrels a day by 2040, an increase of nearly 60% compared to 2014 production levels.

Even within a scenario in which no pipelines are built during this time, the NEB sees oil production reaching 5.6 million barrels a day by 2040—still well above the current production level. But in this case, the oil will have to be transported by train: a less safe alternative. “As numerous studies have shown, pipelines are the most effective, reliable, economical and safest method of transporting large quantities of oil over long distances,” says Chassin.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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