Resources take a sharp dive

The big drama is happening in oil, as prices plunged below US$50 a barrel in early January vs an average of US$93 a barrel this past September. This drop isn’t necessarily resulting in big losses for oil producers, but they are cutting their investments in future production dramatically.

Oil prices could stay low for some time, as the supply/demand imbalance – caused by increases in U.S. shale production and slower than expected global economic growth – is corrected and high-cost producers are forced out of business.

The length of time this shakeout will take depends upon what the new medium-term equilibrium price will be. Some portfolio managers think it will be in the US$60-US$70 a barrel range; others believe it will be in the US$70-US$80 a barrel range; and a few predict it will rise to back to the US$80-US$90 a barrel range. The lower the new equilibrium price, the longer it will take to get there.

For example, Benoît Gervais, senior vice president, investments, and resources portfolio manager with Mackenzie Financial Corp. in Toronto, believes the new equilibrium will be in the US$80-US$85 a barrel range. He says prices could be back to US$75-US$80 a barrel by the spring.

On the other hand, Sadiq Adatia, chief investment officer with Sun Life Global Investments (Canada) Inc. in Toronto, is in the camp that believes the new equilibrium will be in the US$60-US$70 a barrel range. He thinks it’s unlikely that the price of oil will be above US$60 a barrel for most of this year.

When oil prices rebound, though, energy stocks, which have been very badly beaten down, also will move upward. Even portfolio managers who believe that this could be a year or more away already are picking up shares in high-quality stocks issued by companies with good balance sheets that can survive this adjustment period.

Meanwhile, no quick fix is expected for base-metal stocks. Demand is sluggish and likely to remain so because of moderate global growth and reductions in China’s infrastructure spending as that country moves toward greater reliance on consumer spending. There will be significant price increases only when supply shortages emerge, as is expected to be the case for copper by 2017.

However, there are opportunities in forestry products, particularly lumber and packaging, which benefit from accelerating U.S. growth. Prospects for chemicals also have improved with the drop in the price of oil, a large input for chemical production.

Here’s a look at the resources sector in more detail:

– Oil and gas. U.S. shale oil wells have quite short lives, with a 50% depletion rate in the first year, so keeping production up requires drilling new wells. The question is how fast production will drop.

For example, Gervais thinks the impact of reduced new drilling will be felt quickly, with production potentially down this year.

But Joe Overdevest, resources portfolio manager with Pyramis Global Advisors, a unit of Boston-based FMR LLC (a.k.a. Fidelity Investments), doesn’t expect drops in U.S. oil production until 2016.

In contrast, oilsands production has a much different timeline because new capacity costs billions of dollars and takes years to put into place. Thus, current production levels will continue for as long as the price is high enough to cover costs. New projects will be postponed or cancelled for now, but the impact won’t be felt for years.

U.S. shale oil generally requires a price of US$80 to justify new projects while oilsands need a somewhat higher price. However, the price for the latter is likely to fall in the future as new technology lowers costs.

Thus, the stocks that portfolio managers recommend are those of lower-cost producers that have good balance sheets and management. Overdevest recommends Prairie Sky Royalty Ltd., a spinoff of Encana Corp. that receives royalties when others drill on its land; and EOG Resources Inc., which has some of the best U.S. shale assets.

Scott Vali, vice president, equities, and resources portfolio manager with CIBC Asset Management Inc., also prefers EOG, as well as Devon Energy Corp. and Suncor Energy Inc. Gervais recommends Seven Generations Energy Ltd., which went public in November 2014; and Whiting Petroleum Corp. in the U.S.

– Base metals. There aren’t many recommendations in this subsector – with the exception of some for copper companies. In particular, Gervais and Vali recommend First Quantum Minerals Ltd., which is doubling production in the next three to four years. Vali also favours HudBay Minerals Inc.

– Forestry products. Darren Lekkerkerker, portfolio manager with Pyramis Global Advisors who co-manages Fidelity Global Natural Resources Fund with Overdevest, recommends Intertape Polymer Group Inc., which produces industrial tape; CCL Industries Inc., a major label manufacturer; and lumber producer West Fraser Timber Co. Lekkerkerker also suggests Stella-Jones Inc., a Canadian small-cap stock that makes utility poles and railway ties, products for which there’s continuous demand. He says the stock is a little expensive but of very high quality.

Gervais suggests Norboard Inc., a producer of wood-based panels that just announced the acquisition of Ainsworth Lumber Co.

– Chemicals. Lekkerkerker is a big fan of Methanex Corp., which supplies, distributes and markets methanol. He calls the company a “cash-flow machine” and notes China’s rising demand for methanol.

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