Energy funds have posted robust double-digit returns for several years running, thanks to continuing strong demand for natural gas and oil. And with crude oil in the US$70-a-barrel range and natural gas prices stabilized at around US$7.30 per million cubic feet, fund managers say the prospects are still positive.

“We remain bullish on the names in our fund,” says Ari Levy, manager of TD Energy Fund and vice president of Toronto-based TD Asset Management Inc. “But we also believe selectivity is the key to today’s markets.”

Levy has not changed his strategy and continues to focus on companies that have strong long-term growth projects they can finance internally. “We are looking for strong management: people who have experience in bringing on projects in a timely fashion,” he says. “These management teams are keenly aware of cost pressures, and take every opportunity to contain those costs and protect margins for their firms.”

Input costs have risen appreciably, Levy observes, in tandem with climbing commodity prices. There are also labour shortages in some areas. “Virtually everything has gone up — the cost of renting rigs, input costs of all kinds — commensurate with the industry’s better fortunes.”

But the industry is still very profitable. Energy companies can earn low double-digit returns on capital when crude oil is in the low US$40s, says Levy: “So US$60 is a very bullish number.”

But will oil prices stay there? Levy won’t speculate on where crude is going, preferring to focus on companies with strong management and low costs. “Even if oil retreated to US$50 a barrel, we would find the same list of firms attractive,” he says. “If your focus is on finding low-cost producers that are growing organically, and not [on] buying their growth, you would still focus on the same opportunity set.”

Strategically, Levy owns about 50 companies and has a heavy concentration in larger-cap firms. Indeed, senior players, including EnCana Corp. and Suncor Energy Inc., account for about 60% of the fund’s assets. But there is also about 15% in income trusts, most of which were originally stocks in the portfolio, and 25% in small-cap firms. Referring to small-caps, he says: “They give us a degree of diversification and exposure to management teams that are trying to build new companies.”

One of the smaller names is Find Energy Ltd. The firm is active in the Pembina area of Alberta and is primarily a natural gas producer with a daily output of 5,400 barrels of oil equivalent. Acquired about two years ago, its stock fell in early 2005 to $2.50 a share from $4 when results were disappointing. But confident that it would overcome that setback, Levy added to his position.

That move has paid off; the firm later exceeded expectations. “It has increased reserves year-over-year, and finding and development costs were [among the best] in the business on a proven and probable basis,” says Levy. Shares were recently trading at $10.50 a share.

Another favourite is Progress Energy Trust. Formerly Progress Energy Ltd., the firm is primarily a natural gas producer with wells near Fort St. John, B.C., and Gold Creek, Alta., with total daily output of 18,000 BOE. “At $10 per BOE, its finding and development costs are among the lowest of any trust or corporation. It has been very successful in drilling and replacing production,” says Levy.

The company was converted to an income trust in July 2004 at $12.50 a unit. Today, it trades around $17.40 and yields about 9%. “It is still trading at an attractive rate, especially if it adds barrels at or near the lowest cost of its peers.”



Although crude oil prices have fluctuated somewhat in the past few months, natural gas prices have been especially volatile, peaking at US$15.70 per mcf last December, when hurricane Katrina forced the suspension of production in the Gulf of Mexico. Then, when the winter turned out to be much milder than anticipated, prices tumbled to present levels. Yet Aaron Maybin, co-manager of Creststreet Resource Fund and vice president at Toronto-based Creststreet Asset Management Ltd. , is bullish about the commodity. Indeed, the fund is 60% weighted in natural gas, with the remainder in oil production.

“The volatility in gas prices, both on the upside and downside, is because gas storage is too small,” says Maybin, who runs the fund with Robert Toole, managing director of Creststreet. “Prices came off their highs, which we never believed were sustainable.” But when Maybin looks at the futures market — November 2006 prices are more than US$9/mcf and December 2006 is more than US$10 — he’s confident prices will be around US$8/mcf on average for the calendar year.

@page_break@Maybin is attracted to companies in the small-cap sector, which account for 40% of assets. “A number have the capability to generate, year in and year out, 30%-40% production and reserve growth per share,” he says. “The asset base of these companies is growing at an extraordinary rate, such that the movement of the commodity price can be offset by the growth within the companies. We are attracted to their internal organic growth, as opposed to the larger companies that have lower growth rates.”

Although he likes the oil sector, his outlook on the natural gas price is clearer than for crude oil, which, he admits, is much harder to predict:“We are putting confidence in the company’s organic growth, as opposed to making a bet on crude oil. In a flat commodity-price world, we like junior names and focus on them almost exclusively whether the commodity is going up or down.”

Running a concentrated 30-name fund, Maybin is value-oriented but looks for companies with strong growth prospects. One favourite is Crew Energy Inc. A gas-weighted producer, it is active in western Alberta and northwestern British Columbia, and is led by industry veteran Dale Schwed. The company produces 7,200 BOEs a day.

“Looking at its history of growing production, we believe it should be able to achieve almost 30%-plus growth on a per-share basis,” says Maybin. “It has an inventory of exploration wells that could be significant contributors to the company.”

Acquired in late 2004 at $11 a share, the stock was originally part of Creststreet’s flow-through shares limited partnerships. It recently traded at $16.20, or about six times debt-adjusted cash flow. Maybin’s 12-month target is $20 a share.

Another favourite is Rider Resources Ltd. Like Crew, it is a gas-weighted producer and active in the same area, but produces 10,000 BOEs a day. “Management is a top-tier team; [Rider] is the third firm it has run as a group,” says Maybin, noting that the team previously ran Poco Petroleum Ltd., among others. “[They] are very efficient finders of natural gas and oil — and primarily through the drill bit, not acquisitions.”

It was acquired at $4.85 a share in June 2004 and now trades around $15.75, or seven times debt-adjusted cash flow.

“The multiple is fairly high. But it is warranted, given the asset base and land position this company has to grow,” Maybin says. His 12-month target is $20 a share.



Glenn MacNeill, manager of Sentry Select Canadian Energy Growth Fund and vice president at Toronto-based Sentry Select Capital Corp. , is not expecting the robust returns of last year, but believes the outlook is still good. “Crude oil prices will remain relatively high over the long term,” he says. “The supply/demand fundamentals indicate a floor of US$45-US$55 a barrel, which, we think, is a very profitable level for the companies in which we are investing.”

He notes that margins are very high, given that finding, developing and operating costs are low at around US$20 a barrel: “At those levels, there is plenty of cash flow.”

Although demand is driven by China’s and India’s growing thirst for energy, MacNeill also notes that global supply is shrinking because of rapid depletion.

“The wells we are finding are starting production at lower rates than we’ve seen historically and new reserves are lower,” he says. “We’ve had the ‘easy’ oil and [now] have to spend more money to find the oil that is remaining.”

As well, geopolitical tensions in Venezuela, Nigeria and the Middle East are putting additional pressure on oil prices.

Strategically, MacNeill has allocated about 30% of fund assets to energy trusts, 19% to senior producers, 16% to small-caps, 15% to intermediates, 8% to integrated oil firms, 6% to service companies and 6% to cash. Last fall, he pared back the small-cap exposure from a high of 20%, mainly because of liquidity concerns in volatile markets. “It’s a defensive move,” he says. “I’m also trying to stay with quality high-growth companies and move to larger-cap defensive positions.”

One of his largest holdings is Talisman Energy Inc., a senior producer that has been in the fund since 1997. “It has worldwide exposure, good liquidity and continues to be undervalued by the marketplace,” he says. Bought at about $15.25 a share, it is now trading at $62.40 or about four times cash flow. “That multiple is very good compared with its peers, which are in the range of five or six times cash flow.” His 12-month target: $70.

Another favourite is Penn West Energy Trust, one of the largest natural gas producers in North America. “It has a good model for the sustainability of a trust,” MacNeill says, noting the firm has a low payout ratio at 30%. “These are not high-risk exploration people. They take an area, develop it and work hard at getting production going.”

The firm is also a crude oil producer, and last winter successfully tested a carbon dioxide-based technology in the West Pembina area that is expected to boost production when it is introduced on a commercial basis. Acquired last year at an average price of $34.42 a unit, the trust is now trading at $43 and has a 7% distribution of yield. MacNeill’s 12-month target is $45. IE