Full episode: Market Call for Friday, November 16, 2018
Eric Nuttall, partner and senior portfolio manager at Ninepoint Partners
Focus: Energy stocks
In the past month, sentiment in the energy market has taken a U-turn which has resulted in the price of oil collapsing by over $20 per barrel, enduring the longest streak of sequential down-days in history (12 days). Echoes of “$100 oil in 2019” still rang when new narratives of “demand destruction due to trade wars” and “ineffective Iranian trade sanctions” began to take hold. Even one CNBC market commentator has proclaimed that oil could fall to as low as $40. The rate of change in sentiment has been truly incredible: how did the market swing from universal bullishness to the current level of bearishness in just over a month? How could the financial demand for oil fall so sharply while the physical demand continued to grow, remaining at its highest level in history? How could stocks basically flatline with oil rallying by 25 per cent from January to October and then get smashed by 30 to 50 per cent when oil fell?
From our observation, two major events led to the collapse in the oil price over the past month:
- Ongoing trade war escalations by Trump increased fears of slowing global growth and with it concerns that oil demand growth was about to fall.
- The U.S. issued Iranian import waivers to eight countries and this was perceived as a softening in Trump’s stance towards Iran. OPEC+Russia have already increased production by about 1.5 million barrels per day from the May 2018 lows, largely in anticipation of steep Iranian export declines. What happens if Iranian exports don’t fall as much as expected?
There’s also likely been forced unwinding by a U.S.-based commodity trading fund of a short-natural-gas/long-WTI trade and a notable increase in crude futures selling by financial houses that had hedged producers’ output. These factors have exacerbated the oil price fall, perhaps explaining as much as $10 of the $20 decline in crude. While fundamentals definitely loosened over the past several months, they can’t explain a $20 decline. Our sources tell us that Saudi Arabia now feels completely bamboozled by Trump and will champion a larger-than-expected production cut (1.4 million barrels per day or more) at the next OPEC meeting on Dec. 6. OPEC has recently said they will do “whatever it takes” to restore balance and we believe them. Our view that oil is in a multi-year bull market is unchanged. We believe WTI will average about $70 per barrel in 2019 and that it could trade to $100 more in 2020 based on the exhaustion of OPEC spare capacity and non-OPEC/U.S. production entering into a multi-year decline due to chronic underinvestment on long-lead projects.
On Canada, we believe that the combination of shut-ins (over 120,000 barrels per day), crude-by-rail ramping to 455,000 barrels per day by Q3/19, and Line 3 coming online by the end of 2019 will lead to WCS differentials falling to rail economics ($20 to $25 per barrel) by Q3/19. While Canadian light oil midcaps will struggle to attract investment versus Permian peers, Canadian heavy oil companies whose cash flow can double or triple based on a compressing WCS differential will attract fund flows and experience outsized returns.
Last purchased on Oct. 18 at $2.92.
Baytex Energy is our highest conviction assuming $70 WTI and that funds flow returns back to the sector within my lifetime. The market perceives it as a heavy oil producer and yet 37 per cent of its cash flow comes from the Eagleford Basin in Texas, which receives a $5 premium per barrel to WTI. At $70 WTI and a $25 WCS differential, the stock trades at three times enterprise value to cash flow (EV/CF) and a 26 per cent free cash flow yield, with a debt-to-cash-flow multiple of 1.7 times. Baytex is no longer the overleveraged heavy oil producer of years past. With excellent recent results from their East Duvernay play, investors also get free upside on 256 sections in the Pembina area, which offers another leg of growth to the story. These types of names used to trade at seven to eight times EV/CF. Assuming that lower multiples are the “new normal,” a five-times EV/CF multiple at $60 WTI equals to a $3.61 share price (46 per cent upside) or a $6.33 share price at $70 WTI (154 per cent upside). With the stock down by over 50 per cent in the past five months on macro volatility, we continue to be buyers of the stock at every opportunity we get.
PARSLEY ENERGY (PE.N)
Last purchased on Oct. 12 at $28.51.
Parsley is a pure-play Permian producer with a projected 18 per cent yearly growth rate (within cash flow) from now until 2025. It has an inventory base unmatched by any other Permian names of its size. Trading at about three times enterprise value to 2020 EBITDA, the stock offers 134 per cent upside using $70 WTI and normalized Midland oil differentials. Although it has 40 per cent of their 2019 production exposed to widening Midland differentials due to a temporary pipeline bottlenecking, we believe investors will begin to use 2020 normalized differentials in their analysis in the next few months.
DIAMONDBACK ENERGY (FANG.O)
Last purchased on Oct. 12 at $28.51.
Diamondback is merging with Energen in the coming weeks, creating a $21-billion market cap juggernaut in the Permian. With over 7,000 well locations, the company has 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 3.8 times 2020 EV/EBITDA and using a target multiple of seven times results in a $226 stock (100 per cent upside). This stock typifies many of the reasons why investor capital has been leaving Canada to go to the Permian.
PAST PICKS: NOV. 15, 2017
TRICAN WELL SERVICES (TCW.TO)
Sold in January at $4.25, bought back in early February at $3.50, sold in late March at $3.35, bought between May and August at $2.80, and sold in September at $2.40.
- Then: $4.56
- Now: $1.32
- Return: -71%
- Total return: -71%
SOURCE ENERGY SERVICES (SHLE.TO)
Sold 1.8 million shares between February and April at an average price of $6.50.
- Then: $9.58
- Now: $1.45
- Return -85%
- Total return: -85%
C&J ENERGY SERVICES (CJ.N)
Sold between March and April at an average price of $27.
- Then: $29.35
- Now: $18.66
- Return: -36%
- Total return: -36%
Total return average: -64%