Full episode: Market Call for Friday, September 14, 2018
Eric Nuttall, partner and senior portfolio manager at Ninepoint Partners
Focus: Energy stocks
Sentiment towards the energy sector, the Canadian one in particular, seems to reach new lows on a daily basis. The irony of this is that oil has rallied by 17 per cent year-to-date (in Canadian dollars) and by 27 per cent since Jan. 1, 2017. And it’s only sitting modestly below a four-year high. After a four-year-long protracted period of enormous price volatility due to a bombardment of new worry after new worry (which always get debunked with the passage of time), many investors have left the sector in search of easier returns (pot stocks that go up 10 per cent a day, Bitcoin, Apple and Amazon hitting trillion-dollar valuations). This is reflected in both a 15-year low energy sector weighting in several indexes as well as energy stocks trading at a fraction of their historical multiples. Effectively over the past four years, energy stocks have suffered from a massive multiple contraction. Current valuations don’t make sense to us: it’s not normal to be able to purchase a business (using current oil prices) at 3.7 times its enterprise value to cash flow when it has about six years of an existing cash flow stream with 56 per cent operating margins that requires minimal capital spending to maintain (with a total reserve life of 13 years) and whose balance sheet is strong (a debt-to-cash flow of one year). On a free cash flow yield basis (available cash flow after spending to keep production flat), the average Canadian midcap stock is trading at a 15 per cent free cash flow yield. This is not normal.
Given the front-page status of Canadian oil takeaway challenges (heavy, light, and now even condensate), WCS-exposed stocks are fully discounting a wider than likely mid-term WCS differential. We believe investors are getting a free option on any potential positive development, which could shrink the current spot WCS differential by half and result in many WCS-exposed stocks to double:
- Rail capacity is potentially expanding to 500,000 barrels per day by Q3/19. General Electric on Sep. 5 announced an order from CN Rail for an additional 60 more locomotives, which to us suggests incremental capacity adds of 90,000 barrels per day (a 60,000 barrel per day unit train requires a total of 40 locomotives) if all 60 are dedicated to their oil division.
- The Mainline nomination process is evolving to a fixed nomination process, which should eliminate “air barrels” and increase throughput.
- Continuing decline in Mexican and Venezuelan heavy oil exports to the U.S. is increasing demand for Canadian heavy oil.
- The ramp in throughput of the North West Upgrader will increase heavy oil demand by about 80,000 barrels per day.
- The end of the BP Whiting Refinery turnaround, which affects about 250,000 barrels per day of heavy oil demand, will no longer be reflected in spot WCS differentials in a month.
- Pipeline initiatives: Line 3 which is coming online in 2H/19 (380,000 barrels per day of incremental capacity. Enbridge reached a key land access agreement with the Fond du Lac Band this week), Trans Mountain (in late 2021 to early 2022, assuming a one-year delay with 590,000 barrels per day of new capacity reaching tidewater), and Keystone XL (We’ll have a Nebraska Supreme Court ruling by year-end and the Bureau of Land Management and the U.S. Army Corps’ decision regarding permit in January or February 2019. 830,000 barrels per day of new capacity reaching the U.S. Gulf Coast).
We remain very bullish on the price of oil, believing that it could trade over $100 per barrel in the next two years with OPEC spare capacity having been exhausted, U.S. shale production facing pipeline bottlenecks over the next year, demand continuing to grow despite headline worries about trade wars and emerging market contagion, and non-U.S./OPEC production soon entering into a multi-year collapse due to chronic underinvestment. We see many 100 per cent plus opportunities for those patient to wait for the turn, whenever that may ultimately be. For a more detailed discussion go to our website.
PARSLEY ENERGY (PE.N)
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 3.1 times enterprise value to 2020 EBITDA, the stock offers 75 per cent upside using current oil prices ($70 WTI). We also view it as a likely takeout candidate and believe a $45 per share price could be possible (57 per cent upside). Although it has 40 per cent of their 2019 production exposed to widening Midland and WTI differentials due to a temporary pipeline bottlenecking, we believe investors will come back to the Permian stocks in early 2019 and that price-to-earnings is set up to beat 2018 and 2019 expectations.
MEG ENERGY (MEG.TO)
MEG Energy is a heavy oil pure play with roughly 67 per cent of their production exposed to WCS differentials until a pipeline agreement gets expanded whereby only 33 per cent of their production is exposed in 2020. Recently the largest shareholder, Dan Farb of Highfields Capital, resigned from the board and the market has interpreted this as a precursor to him selling over 10 per cent of the shares outstanding in what can be described as a less than favourable backdrop for energy equities sentiment. We believe, given Farb’s background of activism with Tim Hortons, Nexen, and Canadian oil sands, that he’s highly credible and about to launch an activist campaign to unlock shareholder value with MEG. We see a strong disconnect between the current price ($7.10) and what we believe is fair value ($20 net asset value at $60 WTI, $19 share price at $80WTI using a 6-time EV/EBITDA multiple). Not only could an acquirer get a 50-year-plus life asset at a fraction of its net asset value, but MEG also has $4.9 billion in tax losses (net present value of $1.9 billion equates to 40 per cent of their enterprise value), $12 per barrel in G&A and interest expense potential synergies, and regulatory approval to ramp production to 250,000 barrels per day. As the WCS differential narrows due to more rail takeaway capacity coming online over the next several quarters, more heavy oil demand due to the Sturgeon refinery coming online and continued reductions in Venezuelan and Mexican imports to the U.S. Gulf Coast, and incremental pipeline takeaway with Line 3 in the second half of 2019, that the share price could move closer to what we believe to be fair value (around $20 per share). If one is bullish on oil or an improvement in WCS differentials, MEG is the best pure-play available to them.
BAYTEX ENERGY (BTE.TO)
Baytex via its merger with Raging River is extremely well positioned to benefit from current (and higher) oil prices. With a debt to cash flow of below 2 times, the company is well positioned from a free cash flow position next year to potentially dial down growth in its heavy oil business (about 30 per cent of volumes) and initiate a buyback equivalent to around 5 per cent of its shares outstanding. With free cash flow from its Eagleford and Viking assets, we also see meaningful upside through the delineation of their East Duvernay shale play. Finally, given the much improved balance sheet the company is receiving interest from many large institutions that previously would not have met with it given their prior challenged financial position. Trading at 3.3 times EBITDA at $70 WTI and 2.5 times EBITDA at $80 per barrel, we see the stock doubling (or more) if we’re correct in our bullish view on oil prices.
PAST PICKS: NOV. 15, 2017
TRICAN WELL SERVICES (TCW.TO)
- Then: $4.56
- Now: $2.46
- Return: -46%
- Total return: -46%
SOURCE ENERGY SERVICES (SHLE.TO)
- Then: $9.58
- Now: $4.45
- Return: -54%
- Total return: -54%
C&J ENERGY SERVICES (CJ.N)
- Then: $29.35
- Now: $21.10
- Return: -28%
- Total return: -28%
Total return average: -43%