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

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MARKET OUTLOOK

You would be forgiven if you’re feeling either a sense of déjà vu or nausea today after seeing energy stocks suffer another sharp sell-off. The difference this time is obviously the implosion in broader markets (the Dow Jones falling 4.1 per cent on Thursday), which seems to have magnified the selling pressure in oil and energy stocks. 

What's different today when the XOP (The SPDR Oil & Gas Exploration & Production ETF) is trading only five per cent away from the August lows, when oil was at $46 per barrel? Well first, oil is at $60 per barrel. Second, inventories have been drawn down by the greatest extent in history and U.S. surplus storage has fallen from 140 million barrels last March to about 13 million barrels. Third, every U.S. oil company is coming out with capital budgets that show capital discipline, production growth constraint and a renewed focus on returning capital to shareholders, which means that U.S. production growth will be tamer than historical standards. Fourth, oil demand growth is rocking, with Goldman Sachs estimating growth of 2 million barrels-per-day this year. Fifth, OPEC compliance remains very strong and likely to stay that way for all of 2018. Sixth, we are in a four-to-five year bull market for oil (ask for our updated presentation or listen to the webcast coming out next week — or call me).

Where have valuations fallen to? We entered into “cheap territory” a long time ago. At today’s levels, after the 20-per-cent sell-off from the highs two weeks ago (!), our service stocks (whom I met with last Friday … business is good!) have fallen by 25 per cent year-to-date (YTD) as of Feb. 9.

A particular pressure pumper now trades at an 18-per-cent free cash flow (FCF) yield on 2018 and a 22-per-cent FCF yield on 2019 numbers. They’re buying back $100 million of stock (10 per cent of their outstanding) and I think they will buy back even more. 

We had a land driller report results yesterday which slightly missed expectations (first quarter estimates got revised down by two per cent) and the stock sold off by 14 per cent. This is a $4-billion market cap company that lost $400 million of value for a $9-million miss due to very cold weather delaying work in January. UBS this morning actually increased their 2018 estimates by one per cent.

Our oil producers in Canada (only a few of them) can, on average, buy back 15 per cent of their outstanding stock with the FCF being generated today. One pays a 10-per-cent yield already that is well covered. On strip, the average Canadian oil company is trading at 4.6-times enterprise-value-to-cash-flow when they used to trade at seven-to-eight times. Our U.S. producers have been equally mauled falling by up to 18 per cent YTD. In short, there’s been nowhere to hide.

Given the extent of the sell-off after a horrible 2017, people have clearly given up on the space. What is very odd with this is that oil a week ago was trading at a 3.5-year high and even today after the correction, the oil strip is over $50 per barrel out past 2021. Companies are trading at their lowest valuations in memory and are starting to step up to the plate and buy back their own shares, given the very significant disconnect between how their companies are doing and how their stocks are doing. We continue to encourage this action with all of our holdings.

We’re in a multi-year bull market for oil. Fortunes are made when people take advantage of the disconnect between perception and reality. Admittedly, this is the absolute hardest thing to do and the lag time can take longer than one ever thinks possible (like right now). The stopgap is now corporate buybacks. If the investment public won’t step up and buy shares then the corporates will and we’re seeing this in action today.

TOP PICKS

TRICAN WELL SERVICE (TCW.TO)

Trican has been brutalized on concerns about weak spending by natural gas producers, given the horrific backdrop to AECO pricing. We believe much of these spending cuts will be offset by liquids-rich gas drilling, which is based off of condensate pricing. The stock is trading at a FCF yield of 15 per cent to 18 per cent on 2018 and 20 per cent in 2019. Having already bought back over $50 million in stock since late last year, we expect the company to prioritize continued buybacks over fleet activations. Trading at 3.0 to 3.5 times 2018 earnings before interest taxes depreciation and amortization (EBITDA), we see highly compelling value.

KEANE GROUP (FRAC.N)

FRAC is a pure-play U.S. pressure pumper that’s been weak along with its peers on concerns about too much new equipment coming onto the market in 2018, leading to lower pricing. We don’t believe this will be the case. $60 West Texas Intermediate (WTI) should mean pressure pumping demand above 20 million horsepower. When you account for 20 to 25 per cent attrition rates and increasing average spread sizes versus announced and potential new builds, we see the market remaining undersupplied. FRAC is trading at 3.6-times 2018 EBITDA and a FCF yield of 11 per cent.

STEP ENERGY SERVICES (STEP.TO)

STEP Energy has been weak for the same reasons as Trican. in addition to suffering from a liquidity discount due to ARC Financial owning 67 per cent of the company. Pending a sell down by their major shareholder as a means of increasing the float and liquidity, we see the strong potential for a rerate, with the stock trading at 2.80-times 2018 and 1.9-times 2019 EBITDA. The valuation makes absolutely no sense.