MARKET OUTLOOK

The energy market is broken. Crude oil has appreciated by 24 per cent year-to-date and yet many mid-cap energy stocks are down 20 to 40 per cent, demonstrating that there’s a complete buyer strike. Many companies are generating the largest amount of free cash flow in their corporate histories, yet their stocks are making all-time lows. How did we get to this point? Sector performance has been too poor for too long, exhausting investors’ patience; U.S. oil shale supply growth has perverted the market into believing that there are decades of “low-cost” supply available and the Twitter-fueled U.S.-China trade war is dampening sentiment concerning the outlook for global growth.

What needs to happen for sentiment to change and for energy stocks to rerate? U.S. supply growth rates must fall below demand growth rates (happening in real-time), sentiment about the global economy needs to improve (oil demand growth rates have recently inflected in July back to a 1.3 million barrels a day year-over-year) and Canadian exploration and production companies (E&Ps) must collectively use their 10 to 40 per cent free cash flow yields and become the buyers of their own stock, demonstrating the robustness of their existing business models and also hopefully shaking investors from their apathetic comas.

TOP PICKS

MEG ENERGY (MEG:CT)

To us, no stock better typifies the bust in the energy market than MEG. Trading at a 42 per cent free cash flow yield (at $60 WTI and $15 WCS differentials), the company can privatize itself with 2.5 years of free cash flow and would be left with 66 years of remaining production in one of Canada’s highest-quality oil sand projects. Given this distressed valuation, MEG is the most likely takeout candidate in Canada over the next year.

With debt that is a little higher than comfort levels, the company intends to deploy the $570 million of free cash flow per year to reducing its leverage, arriving at the industry norm of 2 times debt-to-cash flow in the next 2.5 years, at which point it could pay a 37-per-cent dividend while keeping production flat. Our initial price target is its proved developing producing (PDP) value, which is $8.50 per share or 65-per-cent upside. MEG is our largest fund holding.

NUVISTA ENERGY (NVA:CT)

Nuvista’s stock price is down nearly 80 per cent over the past year (down 32 per cent over the past month) as the buying interest for even quality small- and mid-cap stocks has all but disappeared. With a likely TSX Index deletion (to be announced Sep. 14), hedge funds have heavily shorted the stock into what has become a vacuum of buying. The market cap of $370 million today is less than the amount they raised in August 2018 ($384 million at $8.10 per share) to buy a highly sought-after asset from Cenovus that had received six other bids.

Nuvista is trading at only 2.6 times enterprise value to cash flow (EV/CF) at $55 WTI and $2.50 NYMEX and 103 per cent of its liquidation value. The stock price has completely decoupled from the long-term value of the company. While outspending its cash flow, the company is on track to generate about $100 million of free cash flow per year in 2021 (with 15 years of proved reserves), which equals a 27-per-cent free cash flow yield. Given this stock traded over $7 a year ago, we easily see a 175-per-cent upside from current levels ($4.47), which would only be four times our 2020 EV/CF estimate at $60 WTI.

CRESCENT POINT ENERGY (CPG:CT)

Crescent Point is trading at 2.8-times EV/CF, at 20 per cent free cash flow yield (2020) and at 71 per cent of its liquidation value (PDP reserve value) despite having six years of capex-free production already on stream. With a potential sale of some infrastructure assets ($50 million of EBITDA at 7 times equals $350 million), we believe the company will use the majority of proceeds to pay down debt (to get to 1.8-times debt to 2019 cash flow) while using the remaining 33 per cent to buy back its shares, given the distressed and highly attractive valuation (26 million shares equals 5 per cent of shares outstanding). With a very strong balance sheet, we look for the company to initiate a meaningful 2020 share buyback program for up to 20 per cent of their shares outstanding while keeping production flat (that is, 20-per-cent production growth per share). A 5-times target EV/CF multiple at $60 WTI equals to a $12.67 share price or 195-per-cent upside.

• Then: $1.50
• Now: $0.58
• Return: -61%
• Total return: -61%

BAYTEX ENERGY (BTE:CT)

• Then: $3.64
• Now: $1.71
• Return: -53%
• Total return: -53%

MEG ENERGY (MEG:CT)

• Then: $7.49
• Now: $5.06
• Return: -32%
• Total return: -32%

Total return average: -49%