'This is a new all-time high in the stock' | CEO of Smead on Cenovus Energy

Key Concepts

• Backwardation: A market condition where the spot price of a commodity is higher than the futures price. It is often interpreted as a signal of tight current supply.
• Contango: A market condition where the futures price is higher than the spot price, often associated with oversupply.
• Diesel Crack Spread: The price difference between a barrel of crude oil and the petroleum products (specifically diesel) refined from it; a key profitability metric for downstream operations.
• Capital Discipline: The industry trend of avoiding "frivolous capex" (capital expenditure) and over-drilling, even during periods of high oil prices.
• Return on Capital (ROC): A measure of how effectively a company uses its capital to generate profit.

1. Market Outlook: Supply Disruption and Investor Sentiment

Cole Smead argues that global investment markets are significantly underestimating the severity and duration of supply disruptions in the Persian Gulf.

• Current State: Smead characterizes the situation as a "60-day stalemate" rather than a short-term event. He notes that the logistics of moving crude to Asia (30–40 days) create real-world supply chain implications.
• Market Misconception: Investors have historically treated energy supply shocks as temporary, but Smead suggests the market is entering a period where supply will remain tight for years, necessitating a shift in investor "faith" toward long-term energy security.

2. Analysis of Specific Energy Producers

Smead highlights three Canadian energy companies, emphasizing their capital allocation and operational strengths:

• Cenovus Energy (CVE):
  • Strengths: Long reserve life in oil sands assets. The acquisition of MEG Energy is cited as a major success, allowing for increased production and the utilization of Net Operating Losses (NOLs) to improve tax efficiency.
  • Downstream Advantage: While Smead generally prefers pure upstream businesses, he acknowledges that current high diesel crack spreads are "minting" money for Cenovus’s downstream operations, providing a unique tailwind compared to independent producers.
• Strathcona Resources:
  • Valuation: Smead identifies this as potentially the "cheapest name in the space," trading at approximately 1.3 times its total capital.
  • Performance: He notes that even if oil prices were to drop to $70/barrel for the remainder of the year, the company is positioned to generate returns on capital between 25% and 30%.
• Tamarack Valley Energy:
  • Governance Issue: Smead advises shareholders to vote against the board’s recommendation regarding a "poison pill" (proposal three), labeling it a "bad idea" despite his respect for the management team.
  • M&A Potential: He explicitly suggests that Tamarack Valley should pursue a merger with Headwaters, viewing it as a logical consolidation move.

3. Methodologies and Market Indicators

• The "Backwardation" Argument: Smead posits that backwardation is a superior environment for oil companies to generate returns compared to contango. He notes that while the futures curve (showing $70 or lower for future years) requires "faith," historical data shows that companies perform exceptionally well in backwardated markets.
• Rig Counts as a Metric: Smead points to the 8–9% decline in U.S. rig counts over the past year as evidence that the industry has been "trained" to avoid capital misallocation. Despite high spot prices, producers are choosing not to over-drill, which supports long-term price stability.
• Valuation Framework: Smead emphasizes that when a company generates 25–30% returns on capital, it should not be trading at low multiples (like 1.3x total capital), suggesting a significant disconnect between current market pricing and intrinsic value.

4. Notable Quotes

• "This is a golden era in the history of the energy business, and it is not going to stop right now. And then people need to buckle up." — Cole Smead, on the current state of the energy sector.
• "Faith is where the big money's at." — Smead, regarding the necessity of betting on long-term supply tightness despite the futures curve.

5. Synthesis and Conclusion

The core takeaway from Smead’s analysis is that the energy sector is currently in a "golden era" defined by structural supply constraints and newfound capital discipline. He argues that investors are failing to account for the long-term nature of these supply disruptions. By focusing on companies with strong capital allocation, such as Cenovus and Strathcona, and maintaining a critical eye on corporate governance (as seen with Tamarack Valley), investors can capitalize on a market that is no longer driven by the "over-supplied" fears of the past decade. The shift from contango to backwardation serves as the primary indicator that the industry has entered a more profitable, disciplined phase.