Mar 8, 2019

Eric Nuttall's Top Picks: March 8, 2019

BNN Bloomberg

Eric Nuttall , BNN Bloomberg

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

MARKET OUTLOOK

The energy market is clearly broken. The sector has posted double-digit negative declines in four of the past five years and investors have largely left it unable to stomach the OPEC and Trump-tweeting induced volatility. The result? Valuations have fallen to the lowest level that I have ever seen in my 16-year career. At an oil price ($60 WTI) modestly higher than the 2020 strip price, energy stocks are trading at over 10 per cent free cash flow yields and at discounts to their proved reserve values. We have holdings that are trading at 36 per cent free cash flow yields with 33 years of proven reserves. This is clearly not normal. Yet each day incremental buying dries up as investors struggle to explain how WTI can rally by 25 per cent year-to-date and still in many cases energy stocks are down on the year. The level of frustration and indifference is palpable.

The curative to this apathy will be the wide adoption of massive share buybacks by companies. With many stocks trading below their liquidation value(that is, the proved developed producing reserve value), management teams should immediately prioritize buying back their maximum allowable amount of shares outstanding as long as their balance sheets allow for it (that is, if debt to cash flow is about 1.5 times and buybacks are financed out of free cash flow).

We’re currently in the weakest period for oil demand (we’re in the refinery turnaround season), yet the weakest barrels of the year are trading at $55 WTI. When 6 million barrels per day of refining demand comes back online, a potential China-U.S. trade deal is announced, Iran waivers are potentially reduced, U.S. production growth disappoints due to the under-spending cash flow using a $50 barrel and Venezuelan production continuing to fall, where will the oil price trade to? At $60 per barrel, we see more than 100 per cent upside in many energy stocks, but this requires investors to care about the space again. This requires a modest rally in the oil price to $60, a lessening in the daily volatility and the demonstration to investors by exploration and production company CEOs that share prices trading below liquidation value is unacceptable and will be remedied by share buybacks financed by egregious levels of free cash flow.

TOP PICKS

WPX ENERGY (WPX.N)

WPX is a top-decile Permian and Bakken producer that can grow by 20 per cent yearly (growing by 22 per cent in 2019). It’s spending within cash flow with a deep drilling inventory (in the Permian of over 30 years and the Bakken of six years), a strong balance sheet (less than two times debt to earnings before interest, tax, depreciation and amortization) and embedded infrastructure optionality which it will continue to monetize over the next few years. Trading at 3.7 times 2020 EBTIDA at $60 WTI, the stock offers 111 per cent upside using a target EBITDA multiple of 7 times.

DIAMONDBACK ENERGY (FANG.O)

After its merger with Energen, Diamondback is now a $20-billion Permian Basin juggernaut with over 7,000 well locations (several decades worth of inventory) and the ability to grow by over 15 per cent yearly within cash flow while still generating excess free cash flow to allow for share buybacks and dividends.

The stock trades at 4.1 times 2020 enterprise value to EBITDA. Using a target multiple of eight times, it amounts to about a $202 target price or 113 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. 15 per cent growth within cash flow at $50WTI plus excess free cash flow (4 per cent) to allow for dividends and buybacks from a $20 billion market cap company … Impressive.

MEG ENERGY (MEG.TO)

This stock to me demonstrates how broken sentiment towards the Canadian heavy oil space is. At $60 WTI and a $17.50 WCS differential MEG would generate $527 million of free cash flow (excess cash flow after spending to keep production flat and satisfy interest payments), resulting in a current 35 per cent free cash flow yield.

While their priority is to use free cash flow to pay down debt (it has a debt to EBITDA of 3.1 times in 2020 at $60 WTI), MEG has 6.5 years of proved developed producing reserves with only $610 million of related future spending so over the next six years. The company could effectively buy back $2.5 billion of stock (170 per cent of all of their outstanding shares) while being left with 27 years or remaining proved reserves. At an EV/EBITDA multiple resembling their proved developed producing reserve life index (6) and $60 WTI, the stock would trade at $10.94 per share, a 119 per cent upside. This is ludicrous.