Aug 17, 2018

Eric Nuttall's Top Picks: Aug. 17, 2018

BNN Bloomberg

Eric Nuttall , BNN Bloomberg

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

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MARKET OUTLOOK

Oil is set for its seventh consecutive weekly decline in what is the worst losing streak since 2015 due to two factors: fear about the strength of the global economy due to trade wars (thank Trump) and the possibility of emerging market contagion (Turkey) as well as a timing mismatch between the production increase by OPEC and Russia versus the pending Iranian trade sanctions that will lower that country’s oil exports by 0.7 to 1.7 million barrels per day (bbl/d).

Energy investors have had to mentally contend with far too many sources of uncertainty over the past several years: China soft/hard landing, sovereign debt crises in Greece, Spain and Italy, Brexit, Saudi Arabia abandoning its role as the global oil swing producer and the consequent crash to $26 per barrel, the U.S. supply increase in shale oil production by around 3 million bbl/d over the past several years and the worry about ever-improving technology, Canadian lack of takeaway capacity and the drama around pipeline approvals, unfounded paranoia about electric car adoption and commensurate demand destruction, royalty regime changes, etc. In short, the average energy investor is feeling burnt out. This is resulting in a buyer’s strike which when combined with fewer overall market participants (many energy funds have shut down and generalist investors are still favouring pot stocks or Amazon or Apple) and dismal summertime trading volumes losses get exaggerated. This has allowed for some high-quality names to fall by as much as 25 per cent over the past month. At the current oil price, energy stocks today are trading at less than half of their historical multiples and at 15-per-cent-plus free cash flow yields. Companies with over 60 per cent cash flow margins and healthy balance sheets shouldn’t trade at three or four times their annual cash flow regardless of the sector. The solution to this all-time high level of complete and utter apathy is both share buybacks (like Trican is buying back 10 per cent of their stock this year) and corporate takeovers (both hostile like Iron Bridge or Trinidad, and friendly like Energen or Raging River).

Despite being able to make an investment case for nearly every energy sub sector (oil, natural gas, services), where we see the best opportunity today is in heavy oil stocks. Pipeline and rail constraints combined with year-to-date production increases (Fort Hills) has led to the WCS differential blowing out from the high teens to a recent high of $30 per barrel and to stocks exposed to the differential imploding by 15 to 25 per cent over the past month. The market is taking today’s unsustainably high level and extrapolating it out forever in their financial modeling of heavy oil companies even though there are many reasons for the WCS differential to narrow back down to around $20 per barrel over the next year: rail is slowly responding with potential capacity of 500,000 bbl/d by Q3/19, the Sturgeon refinery is ramping up to ultimately consume 80,000 bbl/d, the BP Whiting Refinery turnaround will be complete in October, Enbridge Line 3 may become operational in the second half of 2019 adding 370,000 bbl/d of incremental capacity, and Enbridge is attempting to fix the Mainline nomination process which could allow for more “real” barrels to flow through it. Longer term, Trans Mountain construction should soon begin with an in-service date of 2020/2021, heavy oil exports from Venezuela and Mexico are in decline, and Keystone XL still has a chance of going ahead. When one combines this improved WCS outlook with our view that oil will trade in excess of $80 per barrel ($100 per barrel?) next year, we continue to see over 100 per cent upside in several heavy oil names.

Oil remains in a multi-year bull market and we continue to believe that energy stocks today represent an opportunity of a lifetime. This however is not without some heartache and significant frustration along the way.

TOP PICKS

MEG ENERGY (MEG.TO)

MEG Energy is a heavy oil pure play with roughly 67 per cent of their production exposed to WCS differentials until a pipeline agreement gets expanded whereby only 33 per cent of their production is exposed in 2020. Recently the largest shareholder, Dan Farb of Highfields Capital, resigned from the board and the market has interpreted this as a precursor to him selling over 10 per cent of the shares outstanding in what can be described as a less-than-favourable backdrop for energy equities sentiment. We believe given Dan Farb’s background of activism with Tim Hortons, Nexen, and Canadian Oil sands that he is highly credible and about to launch an activist campaign to unlock shareholder value with MEG. We see a strong disconnect between the current price ($7.50) and what we believe is fair value ($20 NAV at $60 WTI, $18.96 share price at $80WTI using a 6-time EV/EBITDA multiple). Not only could an acquirer get a 50-year-plus life asset at a fraction of its net asset value, but MEG also has $4.9 billion in tax losses, $12 per barrel in G&A and interest expense potential synergies, and regulatory approval to ramp production to 250,000 bbl/d. As the WCS differential narrows due to more rail takeaway capacity coming online over the next several quarters, more heavy oil demand due to the Sturgeon refinery coming online and continued reductions in Venezuelan and Mexican imports to the USGC, and incremental pipeline takeaway with Line 3 in the second half of 2019, that the share price could move closer to what we believe to be fair value (about $20 per share). If one is bullish on oil, MEG is the best pure play available to them.

ATHABASCA OIL (ATH.TO)

We’re anticipating that Athabasca will monetize some midstream assets for about $300 million in the next several months and will then close a near debt free entity that offers highly attractive upside at both current and higher oil prices. Athabasca has among the highest cash flow sensitivities to both an increasing oil price as well as a contracting WCS differential and if we’re correct that oil will exceed $80 per barrel in 2019 due to an global persistent undersupply situation then the stock possesses highly meaningful upside. Catalysts include both the aforementioned midstream monetization as well as continued drilling in the Duvernay, which is carried by Murphy Oil. We believe fair value to be $3.44 at $70 oil and $4.66 at $80 using a 5 times EV/EBITDA multiple. The stock is back to trading at less than 50 per cent of its proved reserve value and only 1.6 times the blowdown value of its current production.

BAYTEX ENERGY (BTE.TO)

The “fog of war” is about to be lifted as the merger vote between Baytex and Raging River is next week. Post that event and with the cessation of hate selling from some of Raging River’s shareholders, we believe focus will shift to the profound undervaluation of Baytex. With the stock falling 18 per cent over the past month (oil is down 3 per cent over the same time frame…) Baytex is trading at 3.3 times EV/2019 EBITDA at $70 per barrel and 2.5 times EV/EBITDA at $80. We would view a more normalized multiple of 5 times, which offers 95 per cent/184 per cent upside at $70/$80 oil. Opportunities like this should not exist, but here we are given the complete disconnect between oil and energy equities (from the lows in 2016 oil has rallied by over 150 per cent and Baytex is up 42 per cent).