Sep 28, 2018

Dennis da Silva's Top Picks: Sep. 28, 2018

BNN Bloomberg

Dennis Da Silva , BNN Bloomberg

Dennis da Silva, managing director and senior portfolio manager at Middlefield Capital Corporation
Focus: Resource stocks

MARKET OUTLOOK

The performance of U.S. markets continues to be driven by a combination of tax reform, deregulation and fiscal spending. The S&P 500 Index has now been in positive territory for 114 months, marking the longest bull market in history. Looking forward, we’re optimistic on the outlook for equities as we believe concerns surrounding global trade should subside by the first half of 2019. Although NAFTA negotiations continue, a trilateral deal remains elusive as we head into U.S. mid-term congressional elections in November. Due to the continued pace of revenue and earnings growth, valuations in the U.S. market remain attractive. In Canada, we expect to see stable manufacturing activity as a result of a weaker dollar as well as a continued recovery in the energy sector stemming from healthy oil prices.

The pending Iran sanctions by the U.S. have led to oil prices approaching 2018 highs of just over US$74 per barrel. The continued limits on supply and growing demand have set the stage for oil prices to remain high through most of 2019. Negative sentiment surrounding the Canadian energy space was exacerbated by the Trans Mountain court ruling. The recent blowout of Canadian oil differentials has led to a growing gap between Canadian and U.S. energy companies thanks to a 7 per cent underperformance since August. We see differentials shrinking back to US$25 per barrel from the current US$35, which provides a near-term opportunity. The Shell LNG Canada project, which has the ability to provide access to international markets, is expected to receive a final investment decision before the end of 2018 and will be a key driver of improved sentiment in the near term.

TOP PICKS

TOURMALINE OIL (TOU.TO)
Recent purchases in August around $21.

Tourmaline has been a laggard and it’s oversold given its track record relative to other natural gas names. Now trading at the peer group valuation and well below the historical premium level, the company will be one of the key beneficiaries of a positive decision on LNG Canada. They’re the second-largest gas producer in Canada, with total production of 270,000 barrels of oil equivalent per day (20 per cent liquids). Its performance has been weak despite a solid balance sheet, liquids growth, top tier costs and unique infrastructure control. It’s highly correlated to Canadian AECO prices despite only a 24 per cent exposure given their strong gas market diversification. It has an overall production growth of 15 per cent into 2019 with the start-up of a high liquids cut plant, which will add material liquids growth. All this while spending within cash flow and paying a 1.9 per cent yield beginning this year. Ongoing insider buying is important given the CEO takes no salary.

KELT EXPLORATION (KEL.TO)
Recent purchases in April around $7.80.

Kelt has a premier management team with a large ownership. This is another LNG Canada sentiment change beneficiary. The company has accumulated a large liquids-rich Montney land base of over 1,000 sections in B.C. and Alberta. It’s shown recent weakness given B.C. pipeline restrictions. After spending a couple of years accumulating land and derisking the asset base with small appraisal programs, the company went into harvest/development mode in H2/17 and currently produces 27,000 barrels of oil equivalent per day (40 per cent liquids). Valuation has traditionally been rich on cash flow, but undervalued on net asset value. Shift to development will convert land value into cash flow by growing production, de-risking inventory and improving efficiencies. Its strong gas diversification strategy means they sell 80 per cent of their gas outside the AECO/Station 2 market. Kelt is similar to Tourmaline with a strong multi-zone inventory, infrastructure control and balance sheet.

CARDINAL ENERGY (CJ.TO)
Recent purchase in August around $5.65.

Cardinal is a light and medium oil company in Alberta, producing 21,000 barrels of oil equivalent per day. It offers excellent leverage to higher oil prices and lower Canadian differentials. Spending cash flow to drive mid-single digit growth combined with 8 per cent dividend for an attractive total return in the mid-teens. A large acquisition in mid-2017 has led to the company focusing on balance sheet restoration and the dividend. Very low decline helped offset reduced drilling activity through week oil price period. It’s trading at a large discount to its historical multiple and relative to the junior peer group. A key $330 million light oil acquisition was poorly timed in mid-2017 with a hung $170 million equity deal. But it laid the foundation for lightening the oil mix (50/50 by year-end), improving the profit margin and expanding the drilling inventory.