Full episode: Market Call for Friday, December 14, 2018
Eric Nuttall, partner and senior portfolio manager at Ninepoint Partners
Focus: Energy stocks
Recent months for energy investors have been challenging, testing even the strongest of stomachs with gut-wrenching volatility driven by global macro worries (weakening data points from China and the Asian country’s trade tensions with the U.S.), a confusing OPEC policy (a surge of 1.8 million barrels per day from May in Saudi Arabia, the United Arab Emirates and Russia in anticipation of Iranian export reductions), erratic behavior and policy changes from the White House (from driving Iranian exports “to zero” to issuing waivers to eight importing countries), and surging production from the U.S. and other areas (production in the Lower 48 being up 1.3 million barrels per day year-to-date, while in Libya it’s up 0.4 million barrels per day from the summer).
Net speculative length in Western Texas Intermediate (WTI) and Brent Crude has fallen to multi-year lows. Generalist investors have shunned the space while algorithmic and quantitative funds have continued to press their shorts in a weakening and increasingly illiquid tape, which is now beholden to a buyers’ strike and the largest amount of tax-loss selling in years.
Are fundamentals as bad as a $50 WTI and stocks being down 30 to 50 per cent year-to-date would suggest? Not by a long stretch. While softening demand growth has likely delayed our more bullish view on crude by about one year, we still believe oil to be in a multi-year bull market and that WTI will trade back at $70 per barrel sometime in 2019. Lower temporary oil prices will act as a demand boost and will also negatively impact U.S. shale growth in 2019. We think compliance to the 1.2 million barrels per day cut will be high; the reality is that the cut may be higher than advertised (Saudi Arabia is cutting January production by 0.9 million barrels from November). The world is now only one year away from the non-OPEC and U.S. production cliff after which the group’s production will begin to fall for at least four or five years as the impact of the largest drop in spending on long-lead mega projects begins to be felt. At the same time, global energy demand will continue to increase for many years and by extension oil demand will continue to grow for the next several decades (well beyond the capacity of U.S. oil shale to satisfy it).
Alberta’s mandated shut-ins combined with a ramp in crude-by-rail (over 450,000 barrels per day exiting in 2019) and with Line 3’s in-service date anticipated for the fall, we should see Western Canadian Select (WCS) differentials stabilize at $20 per barrel until either TMX or Keystone XL come online around 2021. Light oil (MSW) and condensate differentials have also materially fallen, helping Canadian producers weather the temporary storm.
While energy stocks have fallen much more than I ever thought possible given a softened but still bullish macro outlook for oil, we feel alone in our call that energy stocks offer a “generational wealth-creating” opportunity. Many stocks that were once viewed as “uber high quality” have fallen by 50 per cent in the past six months. The market isn’t distinguishing between quality and junk. Several energy stocks are significantly lower today than when oil traded at $26 per barrel. Sentiment is the worst I’ve ever seen in my career and the sector is being completely shunned as energy stocks experience merciless tax-loss selling. If one believes only in a $60 WTI, energy stocks offer over 100 per cent upside from current levels. We remain bullish.
BAYTEX ENERGY (BTE.TO)
Baytex offers investors exposure to premium-priced oil production in the Eagle Ford group (37 per cent of cash flow), free cash flow from its Viking light oil asset (24 per cent of cash flow), increasingly profitable heavy oil production at the Seal lands and exposure to the emerging East Duvernay light oil play. At East Duvernay, Baytex holds 255 high-graded net sections of which the company believes it has de-risked around half. The company could be worth 1.5 times the current stock price.
At four times enterprise value to cash flow (EV/CF) with $60 WTI, Baytex trades at its proved developed producing reserve life index. This means investors are getting their two proven reserves (2P) and Duvernay upside for free. Our $60 to $70 WTI target is $4 and $6.70 respectively, offering 62 per cent or 173 per cent upside. Once tax-loss selling ends, this stock could easily rally by over 20 per cent and no one would even notice. When money comes back to the sector, Baytex is the most obvious mid-cap oil stock for beta exposure.
WPX ENERGY (WPX.N)
WPX is a top-decile producer in the Permian Basin and Bakken formation that can grow by 20 per cent yearly spending within cash flow with a deep-drilling inventory (Permian equals over 30 years, while Bakken equals six years), strong balance sheet (less than two times debt to earnings before interest, taxes, depreciation and amortization), and embedded infrastructure optionality which it will continue to monetize over the next few years. Trading at 3.5 or 2.9 times 2020 EBITDA at $60 and $70 WTI respectively, the stock offers 87 or 136 per cent upside using a target EBITDA multiple of six.
PARSLEY ENERGY (PE.N)
Parsley Energy is a midcap pure-play Permian Basin producer projected to grow by over 15 per cent yearly for the next five years while spending within cash flow (at $60 WTI). With a 30-year potential drilling inventory the stock appears to be mildly mispriced, trading at three to 2.5 times 2020 EBITDA using $60 or $70 WTI respectively. It’s difficult to invest anywhere else in the world at this time when you can get such deep and profitable inventory (with no ongoing differential issue) in the Permian Basin at less than half of historical multiples.
PAST PICKS: JAN. 5, 2018
TRICAN WELL SERVICE (TCW.TO)
Sold in January 2018 at $4.25. Return of 5%
- Then: $4.06
- Now: $1.25
- Return: -69%
- Total return: -69%
STEP ENERGY SERVICES (STEP.TO)
Sold in April 2018 at $10.40. Return: -11%
- Then: $11.65
- Now: $2.13
- Return: -82%
- Total return: -82%
SOURCE ENERGY SERVICES (SHLE.TO)
Sold between February-April at $6.50 avg. Return: -31%
- Then: $9.36
- Now: $1.28
- Total return: -86%
Total return average: -79%
With stop-losses: -12%