Sector Watch: Are energy stocks powering up?

“If we compare 2011 to 2012, we had weak gas prices but a pretty strong crude oil market and a good market for natural gas liquids,” says Stelmach, who shares portfolio management duties with Garey Aitken, Bissett’s chief investment officer. (Natural gas liquids include ethane, propane, butane and condensate.) “In 2011, that ‘basket’ of liquids traded in proportion to crude oil. But in 2012, companies shifted their focus to that area and supply began to exceed demand.”

Although prices for condensate, which is used to dilute bitumen, remained strong last year, low propane and butane prices resulted in weaker earnings. “On the crude oil side, margins were better than for natural gas,” says Stelmach. “But higher production in Western Canada started to depress prices. We don’t have great methods to ship from the region to markets other than the U.S. And even the path to the U.S. has been getting blocked.”

The dearth of pipelines has resulted in a large discount, the so-called “differential,” that has hurt producers. For example, the benchmark West Texas intermediate (WTI) may be about US$96 a barrel, but Edmonton par crude, as it’s called, is fetching $94. And heavy oil, known as Western Canada select, is trading at an even deeper discount, at $68 a barrel.

“Today, the discount on WTI is US$8, but the discount for heavy oil is now US$37,” says Stelmach. “That means you’re only getting US$59 a barrel, which is quite a difference. This is reflected in the pace of drilling, which has slowed a bit, and hurt [Alberta’s] provincial revenue.”

The bottlenecks may be relieved eventually, provided projects such as TransCanada Corp.’s Keystone XL pipeline in the U.S. are approved.

In the first half of 2013, Stelmach suggests, “We’ll see more of the same [as 2012]. If we have cold weather in the traditional heating season, that will help natural gas prices. On the crude oil side, the wider differential will persist before moderating, as some of the bottlenecks are addressed. There is nothing on the horizon that will change things quickly.”

Bottom-up managers, Stelmach and Aitken focus on companies with low debt, good cost of capital and strong fundamentals that make it easier to raise capital. From a sectoral standpoint, about 55% of the Bissett fund’s assets under management (AUM) is in exploration and production companies (including integrated oil companies), 33% is in oilfield service providers, 9% is in infrastructure and 3% is in cash.

One favourite holding in the 54-name Bissett fund is Canadian Energy Services & Technology Corp., a specialized firm that produces drilling fluids for horizontal drilling used in the extraction process known as “fracking.” Says Stelmach: “There’s quite a bit of science involved, and working closely with producers to determine the right formulation for drilling in a reservoir.”

Canadian Energy Services stock is trading at about $11.60 a share, or roughly 7.6 times enterprise value to earnings before interest taxes, depreciation and amortization (a.k.a. EBITDA). There is no stated target.

The energy sector turned a corner in the summer of 2012, says Rafi Tahmazian, a partner with Calgary-based Canoe Financial LP who works alongside associate portfolio manager David Szybunka. Tahmazian is lead manager of EnerVest Natural Resources Fund.

“We started deploying our cash because we felt that we had achieved a capitulation point. Picking the bottom is the most difficult thing to do. But the valuations of the group became incredibly compelling, based on historical measures in the past 20 years,” says Tahmazian, who also oversees Canoe Canadian Energy Class Fund. “Good companies were trading north of 7% earnings yield. You should buy that 7% yield all day if you can’t get more than 1.5% for a treasury bill.” (“Earnings yield” is the inverse of a stock’s price/earnings ratio.)

Although energy stocks are already starting to rise and are attracting more investors, Tahmazian says, the next phase will require a more positive macroeconomic backdrop: “If markets start to deem that there aren’t these macro negative issues, you will get so much demand for energy and related stocks that you will have to issue new equity. But there has yet to be enough appetite to satisfy demand. It could happen soon, or in a while. It will depend on these macro issues.”

Clearly, a positive shift in the U.S.’s, China’s and Europe’s economies would propel demand, Tahmazian adds: “Any one of those will drag the others, and the market will recognize that. So, we’re off to the races. What are the chances of this happening immediately? Pretty slim. But over the next year, it’s possible we could turn a corner.”

At the very least, Tahmazian notes, crude oil prices should be supported by stronger growth in emerging markets.

From a strategic viewpoint, Tahmazian maintains a barbell approach within the EnerVest Fund, with about 65% of AUM in defensive positions and the balance in more speculative plays and a small cash weighting. “We own companies that are very good businesses trading at way too high dividend yields,” he says. “If there is any positive movement in the macro environment, the first things that the markets will chase are these yield-focused companies. We will see capital appreciation in that group.”

One of the defensive holdings in the 29-name EnerVest fund is Vermillion Energy Inc., which produces most of its daily output of 50,000 barrels of oil equivalent (BOE) outside of Canada in politically stable jurisdictions. “Two-thirds of its production is exposed to Brent pricing,” says Tahmazian, noting that Brent oil, which is priced in London, is trading at a US$18 premium to WTI.

Vermillion’s stock is trading at about $51 a share and yields 4.7%. There is no stated target.

Tahmazian also likes Raging River Exploration Inc., a more speculative junior exploration firm that is producing about 4,500 BOE a day in southwest Saskatchewan, with the potential to grow to 5,500 BOE. Says Tahmazian: “[This firm has] one of the best management teams and a very strong balance sheet.”

Raging River stock is trading at about $3.15 a share, or roughly six times cash flow.

The turnaround could be close at hand, argues Mason Granger, a portfolio manager with Toronto-based Sentry Investments Inc. who oversees Sentry Energy Growth & Income Fund. The main reason for this, he argues, is that the gap between energy stock prices and the crude oil price is about as wide as it has been in 25 years.

“Stocks are discounting a price for crude oil that is well below where oil is trading today,” Granger says. “They are ‘baking in’ an oil price that is in the low US$70s.”

Granger pinpoints this gap as beginning in early 2011 as the Arab Spring uprisings were taking hold. “Libya was in turmoil, Egypt’s Hosni Mubarak was ousted and there was concern that the uprisings would spread across key producing countries,” says Granger, adding that WTI reached US$114 a barrel in April 2011. But since the market was not convinced that the price increase would stick, he adds, “Stocks did not follow the oil price upward.”

The second factor that has hurt stocks is the renaissance in oil and gas production in the U.S., a result of fracking technology, which has boosted supply and suppressed the WTI benchmark.

But according to Granger, recent analysis indicates that Canadian oil and gas stocks are at a valuation level last seen in the spring of 2009. He points to the ratio of the 48-stock S&P/TSX composite oil and gas exploration and production index to the crude oil price, which indicates the energy sector is at a valuation seen in five similar low points going back to 1987.

“If you were able to hold your nose and invest in energy stocks during these previous periods in which you had significant [price gaps], how were you rewarded as a shareholder?” asks Granger. “In general, you were happy you did because you were up 30% on a total return basis going out 12 months.”

With about 30 holdings in the Sentry fund, Granger emphasizes small- and mid-cap companies, which account for about 75% of the Sentry fund’s AUM. About 20% is in infrastructure and the rest is in cash. As a rule, adds Granger, these firms generate strong free cash flow, reinvest in their businesses and pay dividends.

One favourite name is Bonterra Energy Corp., which has grown through the acquisition of Spartan Oil Corp. and produces 12,700 BOE a day in Western Canada. Says Granger: “We like [Bonterra] because it has a track record of increasing dividends regularly and delivering per share growth in production and reserves.”

Bonterra’s stock is trading at about $47.37 a share and has a 6.6% dividend yield. There is no stated target.

Another favourite is Whitecap Resources Inc., which produces 17,000 BOE a day in Saskatchewan and Alberta. Says Granger: “It’s well positioned to deliver on a stable dividend and growth strategy.”

Whitecap’s stock is trading at about $9.40 a share, or roughly 6.5 times enterprise value to debt-adjusted cash flow, a ratio lower than those of its peers. Whitecap’s dividend yield is 6.4%.

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