Eric Nuttall, partner and senior portfolio manager at Ninepoint Partners
Focus: Energy stocks

MARKET OUTLOOK

The macro backdrop for oil continues to remain positive. WTI has rallied by 40 per cent year-to-date on the back of constrained U.S. production growth, strong adherence by OPEC members to its production cut deal and no meaningful signs of a slowdown in oil demand growth rates despite pockets of global economic weakness. These factors, plus Venezuelan production reaching a multi-decade low, political risk rising in Libya, curtailed production in Canada, technical issues with offshore production in Brazil and the growing possibility of a trade deal between the U.S. and China all point to the likelihood of meaningful oil inventory drawdowns in the months ahead. We project that OECD inventories will exit 2019 at a about 200-million-barrel deficit to the trailing five-year average and that Brent could exceed $80 per barrel ($70 for WTI) by the end of the third quarter.

Despite this backdrop for oil, energy stocks have continued to lag. Memories of the oil price crash in the fourth quarter remain very fresh and have contributed to the highest level of apathy that I’ve ever seen (still) towards the energy sector. What changes this? First-quarter results will demonstrate to the market the cash-flow-generating capabilities of Canadian oil companies given improved pricing and differentials. This should lead to positive earnings revisions, leading to increased quant buying (sadly, an important factor in markets these days). Second, given extremely high levels of free cash flow while stocks valuations remain at perhaps their lowest levels in history, I remain optimistic that some companies will begin to meaningfully buy back their own shares using free cash flow. At $60 per barrel, many stocks are trading at over 15 per cent free cash flow yields and about four times enterprise value to cash flow (EV/CF) or about half of historical valuation levels. As sentiment slowly improves and stocks rerate the trading multiple expansions alone could see many stocks double without the price of oil rallying from current levels.

TOP PICKS

BAYTEX ENERGY (BTE.TO)

Baytex seems to have fallen off of many institutions’ radars for reasons that are beyond me. We like the company as it gives us low cost exposure to Brent-based oil production, trades at a distressed valuation (83 per cent of proved reserve value, 3.9 times EV/CF at $60 WTI) and gives us free optionality on the most scalable emerging play in Canada (East Duvernay), which has the potential to be worth more than its current share price. Their focus remains on using their over $300 million of free cash flow in 2019 to pay down debt and get their ratios to below two times, which should help attract more institutional buying which should allow for a multiple expansion. With four years of zero capex proved developed producing reserves, the company could keep production flat for the next four years and from free cash flow (25 times FCF yield at $62.50) buy back 100 per cent of their shares outstanding, at which point they would still have $3.9 billion of reserve value versus around $2 billion of net debt: $1.9 billion of value for free.

CRESCENT POINT ENERGY (CPG.TO)

Crescent Point has successfully pivoted towards becoming a more returns-focused, shareholder-friendly company over the past year. Of all the mid-cap oil producers in Canada, they’re perhaps the best positioned and most willing to meaningfully buy back their shares using either free cash flow or proceeds from asset dispositions ($600 million of proceeds over the next several months?). Given their current valuation (3.7 times EV/CF at $60 WTI, 20 per cent FCF yield, 79 per cent of liquidation value), we see deep value that will be unlocked by the gradual improvement in sentiment towards the name. With six years of reserves that have no required capital expenditures, the company today could hedge out the next three years of production at $60 per barrel, keep production flat and buy back 60 per cent of their shares outstanding over the next three years. At that point, they would still have three years of zero-capex production ($1.8 billion of free cash flow) and about $7 billion of reserve value (at $55 WTI) versus net debt of $3.5 billion and shares outstanding at that point of 220 million: That’s $15 per share of proved and probable reserve value (using $55 WTI flat).

MEG ENERGY (MEG.TO)

MEG offers the cleanest way to get exposure to Canadian heavy oil production. We expect MEG to sanction their phase 2B expansion once they have clarity around Premier-elect Jason Kenney’s plans for Alberta curtailment resulting in year-end 2020 production of 113,000 barrels per day. Given our bullish outlook for WTI, Canadian heavy oil differentials ($17.50 per barrel for the next few years) and global heavy oil (Maya is trading at a $6 premium to WTI at the moment), MEG energy is a free cash flow beast: Six years of proved developed producing reserves with minimal required expenditures equals $2.5 billion of free cash flow. The stock is currently trading at a 2020 free cash flow yield of 30 per cent (at $60 WTI). That’s not normal. How long until a major oil producer realizes that?

PAST PICKS: DECEMBER 14, 2018

PARSLEY ENERGY (PE.N)

• Then: $16.43
• Now: $20.37
• Return: 24%
• Total return: 24%

WPX ENERGY (WPX.N)

• Then: $12.08
• Now: $14.03
• Return: 16%
• Total return: 16%

BAYTEX ENERGY (BTE.TO)

• Then: $2.37
• Now: $2.66
• Return: 12%
• Total return: 12%

Total return average: 17%

WEBSITE: ninepoint.com
TWITTER: @ericnuttall