Jun 11, 2018

Eric Nuttall's Top Picks: June 11, 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

The oil market is chronically undersupplied and we forecast that OECD inventories will approach all-time lows by October 2020. The last time inventory levels were this low (February 2003), oil demand was only 80 million barrels per day (bbl/d) versus 102 million bbl/d this time. Even assuming tapering demand growth, the full resumption of 1.2 million bbl/d of shut-in OPEC production, U.S. supply growth above which pipeline constraints should physically allow and not accounting for any further barrels removed from the market from Venezuela and Iran (which could be as much as 1.5 million bbl/d), this is the oil market’s reality. Why does no one else see this? No one has done the work.

We will be publishing our 2020 inventory forecast in the next week and will likely be the first to do so globally (we’re not kidding). We believe oil will have to rally to over $100 per barrel in order to kill enough demand to avoid inventory depletion below levels that are required for refineries to properly function. Given a four- to six-year cycle time (the time it takes from spending cash to bringing a large project online), 90 per cent of global oil production (basically everyone other than the U.S.) lacks the ability for the next four or more years to respond to either a demand-induced shortfall or a politically induced supply disruption.

Given the greatest historical divergence in the performance between oil and oil stocks in 2017 combined with our very bullish outlook on oil, we see over 50 per cent upside in energy stocks should they begin to reflect where the price of oil already is and over 100 per cent upside if we’re even remotely close to being accurate in the next two years (we’re using $80 per barrel in our investment decision-making).

TOP PICKS

MEG ENERGY (MEG.TO)

MEG Energy offers the highest torque in cash flow to an improving oil price. While debt isn’t modest, the company is entering into a strong free cash flow period in which debt repayment will occur at a meaningful rate. Given fully funded production growth this year, we see debt-to-cash flow falling to a very manageable level of 2.2 times in 2019. With oil at $80, MEG would trade at around 17 per cent free cash flow yield and have the ability to theoretically pay a 15 per cent dividend per year for the next 50 years from free cash flow using existing reserves. At $80/bbl, we have the company trading at 4.1 times enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) versus our targeted six times, which equals to an $18.78 share price: a 100 per cent upside.

ATHABASCA OIL (ATH.TO)

Athabasca offers the second highest torque in cash flow to an improving oil price. With the imminent monetization of some midstream assets, Athabasca could potentially be debt-free by the end of the year. Offering a 15 per cent production growth compounded annual growth rate (CAGR) over the next several years, the company is growing fast enough to attract U.S. investors while also having the potential to initiate a share buyback given that the stock is trading at a 50 per cent discount to its proved reserve valuation and 2.1 times EV/EBITDA at $80/bbl in 2019 (2.8 times at $70/bbl). Our target multiple over the next one to two years is five times, which amounts to a $4.88 share price or 196 per cent potential upside.

BAYTEX ENERGY (BTE.TO)

Baytex is benefiting from a tightening in the Western Canadian Select (WCS) differential as well as Eagleford having direct access to the Gulf Coast and therefore avoiding much of the current (and worsening) congestion issues arising from lack of pipeline takeaway capacity from the Permian. Trading at three times 2018 EBITDA, at $80/bbl the stock offers potential 150 per cent upside to around $13.50 as sentiment towards oil improves.