Jan 25, 2019

Eric Nuttall's Top Picks: Jan. 25, 2019

BNN Bloomberg

Eric Nuttall , BNN Bloomberg

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

MARKET OUTLOOK

2018 was a soul-sucking experience for energy investors. For the second year in a row, their patience and willingness to endure endless volatility with no reward were tested. What began as mild optimism evolved into euphoric calls for a US$100 oil barrel by midyear, only to see crude prices plunge from October through December by an extent not thought possible by sober minds (47 per cent). Mass financial liquidation led to oil falling far below what physical/fundamental loosening would have suggested and the snap back from the Christmas Eve low of US$42 to now US$53 is proof of that.

We believe that WTI will strengthen to US$60 per barrel by midyear and end 2018 at around US$65. While this is below our more bullish calls from earlier in 2018, we remain bullish on oil in the short, medium and long term. Given the historic dislocation between the oil price and energy stocks over the past several years, any semblance of generalist re-entry into the sector could see many energy stocks rally by 50 to 100 per cent. The confusion and apathy in the energy sector has never been greater, valuations have never been lower (using US$60 oil) and several catalysts exist this year that could propel oil higher than what we’re officially forecasting (and energy stocks along with it).

TOP PICKS

MEG ENERGY (MEG.TO)

Husky deciding to walk from its hostile takeover attempt is a gift to energy investors bullish on the oil price. MEG is the purest way to get exposure to either higher oil prices or narrowing/narrowed WCS differentials.

The market is nearly finished absorbing the 100 million shares that were held by arbitrage investors. As the broader market gets more bullish on higher oil prices and sustainably “low” WCS differentials, MEG should benefit. While concerns about its balance sheet are reasonable at $50 WTI, we believe the market is underappreciating the amount of free cash flow that MEG generates at slightly higher oil prices. At $55 WTI and a $20 WCS differential, MEG will generate $23 million of free cash flow in 2020 and this doubles at $60 WTI to $485 million, resulting in MEG currently trading at a 31 per cent free cash flow yield next year. Using a six-time 2020 target EBITDA multiple, a $60, $65 and $70 WTI with a $20 WCS differential would generate a price targets of $9.50, $14.50 and $19.50 respectively; that’s 80 to 270 per cent upside. A good rule of thumb: every $1 move in WTI above $55 is worth $1 to MEG’s share price.

BAYTEX ENERGY (BTE.TO)

Baytex stock is reflective of the total lack of interest in Canadian midcap oil stocks, hence the extreme undervaluation and poor price action of late (barely up when oil is up, but gets crushed when oil falls). Despite 45 per cent of its cash flow coming from the Eagleford Basin and 35 per cent from the Viking light oil play, Baytex trades like a bankrupt heavy oil company with inferior assets when the very opposite is true. Trading at 3.5 times enterprise value to cash flow (EV/CF) at $60WTI, investors are roughly paying only for the value of existing production and thereby getting 11.5 years of remaining cash flow for free (from proven and probable reserves) as well as free exposure to their Duvernay light oil play in which they’ve derisked 30 out of 255 high-graded sections potentially worth $900 million. At $60 WTI and a five times enterprise value to earnings before interest, tax, depreciation and amortization (EV/EBITDA) multiple, we get a $3.93 target price (74 per cent upside). At $70WTI, we would get a $6.60 target price (194 per cent upside). This stock has decoupled from its fundamental reality.

DIAMONDBACK ENERGY (FANG.O)

Subsequent to its merger with Energen, Diamondback is now a Permian Basin juggernaut with over 7,000 well locations (several decades worth of inventory) and the ability to grow by over 20 per cent yearly within cashflow while still generating excess free cash flow to allow for share buybacks and dividends. The stock trades at 4.4 times 2020 EV/EBITDA and using a target multiple of 8 times, we get a $202 target price or 96 per cent upside. This stock typifies many of the reasons why investor capital has been leaving Canada to go to the Permian and why most of Canadian light oil companies are uncompetitive with their U.S. peers.