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

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MARKET OUTLOOK

The continued buyers strike in energy names (which isn’t just a Canadian problem) combined with renewed global economic growth concerns (which hasn’t translated into meaningfully weakening oil demand; China demand this morning reported at a near-record level) has seen energy stocks completely dislocate from the oil price. Despite oil trading near a four-year high, energy names seem to fall every day as prior buyers have become exhausted fighting an epically tough tape and potential buyers prefer other sectors (that is, weed stocks). The result: Valuations today are the most attractive I’ve seen in my 16-year career, especially considering that I believe that we’re in a multi-year bull market for oil.

What will fix the widest dislocation in history between oil (up 24 per cent in Canadian dollars since Jan. 1, 2017) and energy stocks (down 22 per cent over the same time frame)? Hostile takeovers and corporate share buybacks. We’ve seen a meaningful increase in hostile takeovers (MEG, Iron Bridge, Trinidad Drilling), which indicates that in the view of the most-informed buyer energy valuations have simply fallen too far. Should equity valuations continue to stay at current levels, we believe we will see further hostile (and friendly) takeovers. Further, with meaningful free cash flow being generated now and in 2019, we expect companies to increase their share buybacks, which will both achieve per-share production growth and help provide positive buying momentum which could help sentiment.

Our view continues to be that the best opportunities are in select WCS-exposed names (and this was validated with Husky taking a run at MEG). We view some of these stocks to be doubles to triples when sentiment improves. Negative sentiment towards heavy oil (and Canada) is now at its peak and we expect WCS differentials to begin to compress next week, with the end of the seasonal turnaround at the Whiting Refinery which consumes 10.6 per cent of all of Canadian crude exports.

The total U.S. refinery turnaround season this year has been especially high as well (refining processing was down 1.1 million barrels per day in PADD 2 versus 0.7 million barrels per day last year). This has exacerbated the WCS differential (along with Edmonton light differentials, which today sit at $27 per barrel). This is not well understood by the market. We also expect crude-by-rail to ramp to 500,000 barrels per day in mid-2019 from about 300,000 barrels per day now. With this and Line 3 coming on around November, we believe WCS differentials could fall by half over the next year to around $25 per barrel.

TOP PICKS 

BAYTEX (BTE.TO)
Most recent purchase: Oct. 18, 2018 at $2.92.

Baytex Energy’s stock price is incontrovertible truth that current oil equity valuations make no sense and have completely dislocated from reality. Despite the market’s uninformed view (proof that no one is doing work on energy stocks anymore), Baytex is neither a heavy oil story nor an overleveraged name. Heavy oil will only account for 21 per cent of 2019 cash flow while the Eagleford (which gets a premium to WTI pricing) will account for 41 per cent. After their merger with Raging River debt is no longer an issue, with debt to cash flow now at 1.7 times. How cheap is Baytex with it down 25 per cent year-to-date? The company trades at 3.1 times its enterprise value to cash flow despite having 3.5 years of proved developed producing reserves (that is, this requires no capital) and at a 19 times free cash flow yield. In a normally functioning market where there were active participants, a name like Baytex would trade at a five to seven times enterprise value to cash flow multiple. Using $70WTI and $25 WCS differentials (they will rail 34 per cent of their heavy oil), Baytex would trade at $6.62 per share at a 50-time 2019 multiple, which equals to a 135 per cent upside. If you assumed that in 2019 they had zero cash flow from all of their heavy oil yet still burdened them with general and administrative expenses, the stock would still trade at only 3.7 times enterprise value to debt-adjusted cash flow. With Baytex, you get a stock that trades at 60 per cent of a normalized multiple and a 19 per cent free cash flow yield which has fallen by over 50 per cent in the past five months, has 41 per cent of their cash flow stream coming from the U.S. and gets a premium to WTI pricing. You also get completely free optionality on both their East Duvernay exploration play as well as delineation of their Northern Seal play where they are drilling top decile economic wells under normalized heavy oil differentials. In the next two years, we think Baytex has a shot at trading at $10 per share versus $2.82 today.

WPX ENERGY (WPX.N)
Most recent purchase: Aug. 1, 2018 at $17.92.

WPX is a producer that has five years of premium Bakken locations and over 30 years of Permian inventory. It can grow by over 25 per cent yearly over the next two years while still generating excess free cash flow, and it also has a solid balance sheet with debt to EBITDA of about 1.5 times. Trading at 3.9 times 2020 EBTIDA using $70 WTI, we believe WPX will ultimately trade at a six-time multiple, which would offer 64 per cent upside at $70 WTI and 98 per cent upside at $80. Given their inventory depth, we believe this name offers many years of visible top-tier production growth (within cash flow).

ATHABASCA OIL (ATH.TO)
Most recent purchase: Aug. 15, 2018 at $1.39.

With MEG being bought by Husky (or someone else), Athabasca will become the stock that has the highest operational leverage to an increasing price of oil or a falling WCS differential. For oil bulls, it will become the go-to way to play higher oil prices. We believe that as sentiment towards WCS improves and differentials compress back to $25 in 2019 that Athabasca will get rerated and could easily trade above $2 per share (it was there five months ago). Longer term, with crude-by-rail, Line 3, and either Keystone XL or Trans Mountain coming online, we believe WCS differentials will fall below $20 per barrel in 2021. Given Athabasca's 27-year proven reserve life index (75-year proved and probable reserves), the vast majority of their future cash flow will enormously benefit from compressed differentials (and higher oil prices) versus the weakness being seen today. With a $70 to $80 WTI price and $15 to $20 differentials, Athabasca would trade at two times enterprise value to cash flow, offering well over 100 per cent upside. Look for a midstream monetization in the weeks ahead that will eliminate around 75 per cent of their total debt, leaving them in excellent financial shape.

PAST PICKS: JAN. 5, 2018

TRICAN WELL SERVICE (TCW.TO)

Recommended on Jan. 5 and sold in mid-March. Bought back in late summer and sold in September. We have been buying back in recent days. Trican’s trading activity has revolved around views on AECO pricing, producer spending plans, Canadian light oil differentials, and risk/reward of service names versus producers.

• Then: $4.06
• Now: $1.97
• Return: -52%
• Total return: -52%

STEP ENERGY SERVICES (STEP.TO)

Began selling in early February to April between $6 and $8. We sold it after disappointing results following their dilutive acquisition that appears to have been made near the top of the market and eliminated their ability to generate as much free cash flow as we had originally believed.

• Then: $11.65
• Now: $4.28
• Return: -63%
• Total return: -63%

SOURCE ENERGY SERVICES (SHLE.TO)

Sold in April between $9.94 and $10.50. We sold on the view that their Tucker acquisition was poorly timed and that U.S. pressure pumping outlook was deteriorating much faster than the market believed at the time.

• Then: $9.36
• Now: $2.98
• Return: -68%
• Total return: -68%

Total return average: -61%

TWITTER: @ericnuttall
WEBSITE: www.ninepoint.com