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

MARKET OUTLOOK

The market remains paralyzed by fears of weak oil demand growth despite some leading edge data pointing to a positive inflection. Year-over-year growth was 850,000 barrels per day in August for countries accounting for about 50 per cent of global demand, global refining margins remain healthy and the U.S. oil surplus in inventories has contracted from 56 million in May to now less than 16 million. A t the same time, U.S. year-over-year production growth rates have decelerated from 1.9 million barrels per day in August 2018 to 1.1 million in July due to self-imposed spending constraints and the lack of material well productivity improvements. While the market will need to absorb incremental barrels from a confluence of new projects coming online (Johan Sverdrup, Brazilian offshore and Liza in Guyana, all amounting to 1 million barrels per day), in the short-term we see global inventories drawing in 2020. More importantly, in 2021 we believe the combination of faltering U.S. production growth rates coupled with declining global offshore production will lead to material inventory declines resulting in much stronger pricing. This will mark the beginning of the next bull market for oil, where the U.S. can no longer act as the global swing producer and marginal supply costs of $60 WTI will matter once again.

With that said, the interest level in energy stocks in Canada and around the world today remains non-existent. In Canada, the spectre of tax-loss selling and fears of a Liberal minority government with a Green or NDP coalition are keeping potential inflows on the sidelines. Energy stocks already discount a continuation of the status quo (a Liberal government) since their valuations while burdened with the realities of today (lack of egress, relying on expensive crude-by-rail, carbon taxes) remain at all-time lows (10 per cent free cash flow yields and at half of historical cash flow multiples). While a knee-jerk sell off is possible on Oct. 22, energy stocks already discount the worst (other than a NDP majority). We continue to deploy capital into names that are paying us over 9 per cent sustainable dividends while trading at a discount to their liquidation value. With ongoing share buybacks ($5.8 billion year-to-date) in 2020, we believe that energy stocks remain severely undervalued.

TOP PICKS

ENERPLUS (ERF:CT)

Enerplus is an under-levered oil producer (0.5 times debt to cash flow) with a 10-year drilling inventory in the U.S. Bakken. Trading at 3.2 times enterprise value to cash flow ($55WTI) and at 98 per cent of its liquidation value (proved developed producing reserve value) the stock is mispriced relative to its asset quality and ability to meaningfully buy back stock (it’s bought back 12.5 million shares year-to-date). Were Enerplus to use $200 million of debt to buy back shares given its distressed valuation, its leverage ratio would only increase to 0.8 times (that is, it would still have a top-tier balance sheet) and yet would allow them to buy back almost 10 per cent of their shares outstanding. When the interest level in energy stocks was higher, names like Enerplus used to trade at 8 times EV/CF. Now they trade around 3.5 times cash flow — talk about multiple compression.

TORC OIL & GAS (TOG:CT)

Torc is run by a very competent management team that has earned the reputation of under-promising and over-delivering. With a rock solid balance sheet (1.1 times debt to cash flow) and the support of CPP (29-per-cent ownership position), Torc offers lower risk exposure to a rising oil price. With a dividend yield of 8.4 per cent that is sustainable down to $50 WTI, the stock trades at 3.6 times EV/CF ($55 WTI) and at only 99 per cent of its liquidation value (PDP reserves). Given the distressed valuation, we look for Torc to announce a “stay-flat” 2020 budget that maximizes free cash flow to allow for a 5 to 10 per cent share buyback program while allowing for a modest dividend increase.

ARC RESOURCES (ARX:CT)

There was a time not long ago when ARC was considered the gold standard of Canadian energy stocks (A-plus management team, strong balance sheet, superior asset quality). Yielding 11 per cent (sustainable at $50 WTI and $2.50 NYMEX gas) and trading at only a 9-per-cent premium to its PDP reserve value (its liquidation value), the stock has clearly lost its entire premium multiple. Given the depth of its asset base and ability to internally fund growth, we see the company being able to grow 2021 cash flow by 20 per cent and still be able to pay an 11-per-cent dividend while keeping its balance sheet rock solid (1.1 times debt to cash flow at $55 WTI).

PAST PICKS: OCT. 19, 2018

BAYTEX ENERGY (BTE:CT)

• Then: $2.99
• Now: $1.71
• Return: -43%
• Total return: -43%

WPX ENERGY (WPX:UN)

• Then: $18.13
• Now: $10.35
• Return: -43%
• Total return: -43%

ATHABASCA OIL (ATH:CT)

• Then: $1.52
• Now: $0.56
• Return: -63%
• Total return: -63%

Total return average: -50%