Eric Nuttall's Top Picks: Oct. 16, 2020

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

MARKET OUTLOOK

The oil market continues to heal from the COVID-19-induced demand shock. Demand is currently down about 6 million bbl/d, largely driven by a reduction in global jet fuel demand as well as regional weak spots for gasoline/diesel (predominantly in North America). While 99.9 per cent of the market’s attention is on demand loss, it is transient. What the market is totally missing is the impact on supply growth going forward. Already, the global oil industry was underinvesting in new production which is required to both satisfy demand growth and offset declines. Looking forward, we believe the era of U.S. shale growth is largely over (Occidental yesterday said U.S. supply will never again hit 13 million bbl/d); this is a watershed event for the energy market as the U.S. was responsible for 100 per centof non-OPEC supply growth over the past five years. Additionally, over five years of insufficient investment in new offshore projects and the final harvesting of projects that were sanctioned back when oil was $90 will result in flat/declining global offshore production.

In the nearer term, the IEA is guiding for stock draws of 4.1 million bbl/d in Q4; if proven accurate, this will completely eliminate the inventory builds from earlier this year as well as eliminate almost all offshore storage resulting in a balanced market. The market is simply too pessimistic about the outlook for oil and worries around peak demand will ultimately lead to peak supply due to insufficient investment (global supermajors investing more in renewables) and the depletion of economic U.S. shale reserves.

We remain bullish and still think oil could rally close to $50/bbl by year-end. Even at $40 we have investments in Canadian oil companies that have current free cash flow yields in excess of 10 per cent offering free optionality to better days in the months ahead.

TOP PICKS

TORC OIL & GAS (TOG TSX)

A top pick for several shows now, TORC offers compelling valuation using strip pricing (which is unsustainably low) and very meaningful upside in a better oil price environment. At strip pricing of $43 WTI in 2021, TORC could generate free cash flow of $67 million equating to a 20 per cent free cash flow yield (that is, they could privatize themselves in five years at the current oil price). We think oil could rally to $50 WTI in late 2020/early 2021 and eventually $60 by year-end 2021, at which time TORC would be trading at a 37/64 per cent free cash flow yield. Given management’s reputation for delivering, adequate balance sheet strength and ability to weather the storm we see upside of 161/297 per cent upside using a five times multiple at $50/$60 WTI. Further, with CPP as a major shareholder we hope TORC is able to scale up in order to gain greater relevancy via M&A.

TOURMALINE OIL (TOU TSX)

Tourmaline is an “easy-to-own” way to gain exposure to a stronger natural gas market: huge inside ownership, strong free cash flow (16 per cent FCF yield adjusting for Topaz ownership), disciplined growth, a large enough market cap to be relevant to larger institutions ($4.6 billion) and attractive valuation (3.5 times EV/CF at strip natural gas prices and $50 WTI). The backdrop for natural gas has improved: no more associated gas production from oil drilling, recovered LNG demand, falling dry natural gas production in the U.S., improved Canadian regional infrastructure and crippled U.S. marginal swing producers which means the cycle should last longer than historically. Assuming normalized weather this winter, gas can potentially exceed $4/mcf before supply responds.  Given current valuation of only 3.5 times EV/CF when other U.S. natural gas companies trade at over 6 times, we see the potential for multiple expansion to 6 times: that’s $31.64/$37.70 at strip natural gas prices and $50/$60 WTI, or an 86/122 per cent upside.

PRECISION DRILLING (PD TSX)

Precision Drilling has had to operate in the worst possible environment imaginable this year (U.S. rig count down 69 per cent) and yet was able to generate positive free cash flow. Looking forward, if one believes in $50 WTI in 2021 and E&Ps spend enough to keep production flat, it is possible that Precision Drilling could generate free cash flow equivalent to its current market capitalization. This provides meaningful optionality to a more normalized oil pricing environment in the months ahead.

PAST PICKS: NOV. 15, 2019

Parex Resources (PXT TSX)

• Then: $20.66
• Now: $14.34
• Return: -31%
• Total Return: -31%

Whitecap Resources (WCP TSX)

• Then: $4.16
• Now: $2.53
• Return: -39%
• Total Return: -33%

TORC Oil & Gas (TOG TSX)

• Then: $3.75
• Now: $1.53
• Return: -59%
• Total Return: -58%

Total Return Average: -41%

Twitter: @ericnuttall 
Website: www.ninepoint.com