The Days Ahead:

  • Jobs numbers; short trading week.

This Week:

  • A new law in Canada regulates what companies can say about the environment.
  • The law is draconian and impractical.
  • Oil companies have been badly hit.
  • And it creates chaos for many.
  • The French elections come at a bad time.
  • France may be headed to a split government at a time of rising debt.
  • Companies are hoarding cash.
  • They’re another source of Treasury demand.

Programming Note:

  • There will be no Market Digest next week. You can find regular updates from the Cerity Partners Investment Office here.

Oil Sands Companies and When Regulations Go Wrong

Last week Bill C-59 passed its third reading in the Canadian House of Commons. This is the final step before it’s sent for Royal Assent to become an official act of Parliament and law.

C-59 is a broad economic and business bill covering tax benefits, use of excessive interest to limit tax deductibility, updates of business transfer rules, equity repurchase limits, tax rebates on rental construction and digital services taxes. It’s standard stuff and not meant to cause any fuss.

Except it includes a few changes to the Competition Act that basically says no company can discuss the benefits of protecting or restoring the environment:

“That is not based on an adequate and proper test, the proof of which lies on the person making the representation and in accordance with internationally recognized methodology.”

This doesn’t sound onerous unless you’re in the business of power generation, green energy or carbon capture. The Pathways Alliance website, set up to represent many of these companies deleted all but its home page the day after the bill passed.

Figure1 Pathways Alliance Images
Source: Pathways Alliance

We’d agree there’s a genuine problem with “greenwashing” when companies or countries claim progress on environmental clean ups without doing much. In a bad case a company can claim to have a net-zero pollution target when it doesn’t. Or a company might cite one environmental goal (“we recycle all our water”) while ignoring others (“we had to dam a few rivers to get there”). The new law takes aim at energy companies by prohibiting companies from claiming any progress on the environment unless the claim has been tested and the results published.

The law puts the onus of proof on the company. This means any six residents in Canada over the age of 18 could say to the Competition Bureau (the enforcing agency) “that windmill does not help the environment.” The windmill’s owner would have to prove every step it took to build the windmill was in line with “internationally recognized methodology.”

The problem is there is no such methodology. You can get an accreditation from Det Norske Veritas (DNV) which will certify that your wind turbine is up to scratch and won’t fall down in the next storm. But it won’t meet the standard set out in C-59.

Likewise you can build a plant and receive a zero carbon certification from the impressive sounding International Living Future Institute but those tests aren’t universally recognized. A Canadian company can’t make any assertions that what they did to recycle carbon, clean up, or replant helped anyone or anything.

Reverse-onus provisions are tricky. In court a litigator does not have to prove the statements are misleading. The company must prove that they’re “substantiated.” Nor can they use a “good faith” defense. It’s hard to think of a tougher disincentive to reach net-zero goals. For the extractive industry, anyone can challenge a company’s statement about pursuing or publishing clean innovations and opening it up to fines of $10 million.

The mission of the Pathways Alliance was to reach net-zero operations for all Canadian oil sands companies.

Oil sands are a mix of clay, water, and bitumen. The bitumen contains the equivalent of 20% oil. It requires open-cast mining and digging out two tons of sand to extract one barrel of oil. It also requires around six gallons of water to produce one gallon of gasoline. The water is stored, with a lot of toxic substances, in huge 30-square mile ponds. It’s not great and everyone, including the companies, wants to see a cleaner process and less waste.

Oil companies are trying. They set up a core project for carbon capture and storage (CCS). This is a 45-year old proven technology used to offset environmental impacts. It takes CO2 from mines and refineries before it’s released into the air and pipes it to a station where it is pumped 5,000 feet underground. The gas then blends with and stays permanently trapped in the geology, a depleted gas field or a saline aquifer. One storage site can store 100 million metric tons of CO2 every year, which is equivalent to the emissions of 20 million cars.

There’s even a Global CCS Institute operating in 11 countries which has advocated the process since the mid-1990s.  Bill C-59 allows anyone to challenge oil companies to prove stored gas never again reaches the surface. The technology does not exist to prove that. Most companies deleted all information about their CCS projects rather than face fines.

The companies involved are Canadian Natural, Imperial Oil, Meg Energy, ConocoPhilips, Suncor and Cenovus with a combined value of $332 billion, sales of $201 billion and 50,000 employees. They’re none too pleased stating that:

“Our ability to remain transparent has been significantly compromised as a result of Bill C-59…it is possible that certain public representations by a business about the benefits of the work it is doing to protect or restore the environment…will violate the Competition Act and subject it to significant financial penalties unless the business can adequately and properly substantiate their claims according to “internationally recognized methodology,” which may or may not exist.”

There’s more, but you get the drift: we can’t talk about what we’re doing to help clean up our operations but we are trying.

The Canadian Association of Petroleum Producers, a broad industry group, has weighed in and withdrawn all information on its website and social media feeds. The Calgary Chamber of Commerce, where most of the oil sands companies are based, asked for the immediate removal of all the relevant parts of the bill.

No one’s happy including shareholders who saw share prices take a dip:

Figure2 Canadian Stocks Graph
Source: FactSet, 06/21/2024

We’re not sure how this will end. It surely serves no good to close down communication on net-zero initiatives from the world’s major oil companies producing 53% of Cananda’s 5.8 million barrels of oil every day. Canada is the world’s fifth largest oil producer and by far the largest supplier of foreign oil to the U.S.

It’s not just oil companies. used Bill C-59 to file a complaint that Lululemon exaggerates its claims to reduce pollution. Even if the Competition Bureau finds nothing, the accusation will stick.

We’re all for regulation especially in something as messy as oil sands extraction. But rules that cut off communications and transparency just seem to us like a needless own goal.

President Macron Made a Mistake

The June 6th elections for the European (EU) Parliament did not go well for the French President. The EU  parliamentary parties are different from those in the national elections. Every national party aligns themselves with a pan-European party from which voters pick. The French right wing Rassemblement National (RN) party, under Marine Le Pen, for example, aligns with the Identity and Democracy (ID) EU Party along with Germany’s AFD, the Netherland’s PVV and Italy’s Lega.

The ID won 30% of the EU Parliament votes and the RN won 31% of the vote French vote, more than double the parties allied in the centrist group which includes President Macron’s Renaissance party.

The strong showing of the RN prompted Macron to call a snap election, hoping, it seems, the electorate would not dare hand a second victory to the RN party.

Five major parties in France control 70% of the domestic parliament. Another 33 parties hold the remaining 30%. Macron’s Ensemble party and other centrists have 43%. If the national election turns out the same as the EU election, Macron’s parties would end up with 14% of the votes and the RN and Reconquête, a far right party, would have 36%. If you add two left wing parties of La France Insoumise and Les Ecologistes (who have combined into the Nouveau Front Populaire), the far right and left would have 56% of the vote. Macron would be squeezed in the middle.

The first stage of the election is on June 30th with the run off on July 7th. The Olympic Games start three weeks later.

The vote could not have come at a worse time for Macron. He’s run a strong economy since 2017 based on supply side reforms on pensions, retirement age, trade-unions, and abolishment of some local taxes. There were also stimulus plans to combat Covid-19 and the energy price shock from Russia’s invasion of Ukraine. Unemployment dropped to its lowest level since 2008.

But the deficit also grew to 5.5% and the EU recently sent one of its excessive deficit procedures reports asking for spending reforms. The policies of the major left and right parties are not clear but include:

Left parties: a wealth tax, a 100% renewable economy, a 30% increase in the minimum wage, 90% capital gains tax and a decrease in the retirement age.

Right parties: a drop in the value added tax (VAT) from 20% to 5.5% on fuel and energy, a nationalization of highways, employer tax exemptions, also a decrease in the retirement age, border reform and a cut in rebates to the EU.

If all those sound expensive, they are. They certainly wouldn’t get France to the 3% deficit limit requested by the EU.

As of Thursday, the polls have the RN and allies at 36%, the Nouveau Front Populaire at 28% and Macron’s Ensemble centrist group at 21%.

The markets were initially worried about the prospect of “cohabitation” where the prime minister and president are from different parties. It has happened before but was not a happy experience.

French government bonds widened out, meaning they yield 0.7% more than German bonds. S&P lowered France’s credit rating to AA- and Moody’s issued a “negative” watch.

Stocks fell by around 9% but have since recovered. Banks, seen below, were badly hit. They hold large amounts of debt and would likely see higher borrowing costs.

Figure3 French Banks Graph
Source: FactSet, 06/25/2024

We’d expect French stocks to recover. The CAC 40, major stock index only generates 15% of its sales from France, and international stocks like LVMH, Kering, Sodexo and L’Oreal derive less than 5%. Stocks with a high exposure to France, like toll road companies, utilities and lottery companies are down sharply.

Meanwhile, Sunday’s first round vote should give us a clearer idea on who the next Prime Minister will be and whether it’s someone President Macron can work with.

Companies Holding Cash

We wrote a lengthy piece last week about the budget deficit. One common question is who will buy our debt? The short answer is everyone. Households are rapidly increasing their holdings of U.S. treasuries, up by four times in the last three years. Foreigners hold record amounts of U.S. treasuries, around 28% of the total. Banks hold 40% more treasuries than they did pre-Covid-19. Investment funds now own 65% of Treasuries compared to 48% four years ago.

An astute colleague noted that we can add businesses to that list. They have increased their cash holdings (in the green line in the chart below) by 50% in the last few years and as a percentage of GDP reached around 7%, compared to a pre-Covid-19 level of 2.8%.

Figure4 Non-Fin Cash Graph
Source: FactSet, 06/26/2024

Why are companies holding so much cash?

One obvious reason is that they can earn more from it now than they have since October 2000.

Some may be hoarding cash. If the next administration levies 10% tariffs on all imports and 60% on imports from China, companies may want to purchase goods ahead of time.

Companies may be channeling their inner Logan Roy and waiting for acquisition opportunities.

Some will hold cash overseas, where taxes are lower. As we’ve discussed before, it’s easy for a company to shift license and royalty payments to lower tax jurisdictions.

Or it may just be insurance against shocks, competition, high borrowing costs and reduced access to bank lending. After all, cash on hand is more attractive than having to roll over variable rate debt with a bank that may not want to lend to your industry anymore.

Companies are retaining more cash than normal for a variety of reasons, but it also makes them net buyers of Treasuries. Add another buyer to that column of “who will buy the debt?”

Bottom Line

Looking at the charts this week, you’d think summer trading had already set in. The S&P 500 had a trading range of less than 0.1% compared to 5% for the last month. It’s less than 0.4% off the all-time high of June 20, 2024.

The 10-year Treasury traded between 4.25% and 4.28% except for a brief period when inflation numbers from Canada and Australia printed higher than expected. Treasury auctions of $180 billion went smoothly. Demand remains fine.

The PCE inflation was revised up for Q1. That’s way in the rear mirror by now but it’s more evidence that the road to low inflation is bumpy. Wholesale and retail inventories rose more than expected. That’s good for growth but may mean companies don’t need to stock up so much for a while. The May goods trade deficit was much larger than expected. That does not help Q2 growth

We’re watching the French elections. Call us superstitious but EU flare-ups tend to happen in the summer.

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Art of the Week: Andre Derain (1880-1954)

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