Energy stocks have been in a slump since late 2006 because of a combination of weakening commodity prices, rising costs and last fall’s surprise federal decision to tax royalty and income trusts.

Some fund managers are more wary of the sector, but others are staying the course, arguing that the bearish phase is temporary and should have little impact on the secular trend.

One cautious optimist is Greg Bay, manager of EnerVest Natural Resources Fund and president of Vancouver-based Cypress Capital Management Inc. “A lot of gas producers were hurt in the fourth quarter, when commodity prices went down to US$4.50 per million cubic feet from US$7.50,” says Bay. “That forced them to cut back on their capital expenditures, and we’re now seeing the results.”

Many junior firms that operate in the Western Sedimentary Basin and have a bias toward natural gas production have seen their stock prices slump.

At the same time, Bay notes, so-called “finding and developing costs” have risen dramatically, as land costs and drilling services have escalated. “The results have not been stellar, so share prices have drifted down,” he says. “It varies, but some companies are trading at deep discounts to their net asset value.”

In Bay’s view, the trend will result in a consolidation of the junior players over the next 12 months.

Bay is generally taking a wait-and-see stance. Some stocks are trading at deep discounts but others haven’t got there yet. “Valuations could still come off. It varies from name to name,” he says. “Short-term, though, I’m being cautious. You don’t know how much further valuations could drop.”

Bay bases his valuations on natural gas at US$7.50 per mcf, slightly higher than the recent US$7. He also anticipates that crude oil will remain in the US$50-US$60 a barrel range. It was recently around US$57. His view is predicated on a weakening U.S. dollar relative to the Canadian dollar, higher costs and worrisome decline rates in the Western Sedimentary Basin, which effectively means mature oil and gas fields are producing less.

Bay runs a 45-name fund that is a liquidity vehicle for his firm’s flow-through share activity. He has allocated about 40% of the portfolio to large holdings in large-cap, liquid names such as EnCana Corp., Canadian Natural Resources Inc. and Talisman Energy Inc. There is also about 10% invested in service firms, but the balance of about 50% is in junior players. Lately, he has added to some names that have experienced share price weakness.

For instance, Bay likes Cork Exploration Inc. Primarily a natural gas producer, it produces about 3,300 barrels of oil equivalent and is active in central and northern Alberta. It has potential to produce 5,000 boe by the end of the year. “It’s a well-managed company and is trading at or slightly below its net asset value,” says Bay. Bought during the initial public offering in late 2005 at $4 a share, the stock recently traded at $3.30. Within the next 12 to 18 months, Bay says, the stock could rise to $5 a share.

Another favourite is Cyries Energy Inc., which operates in Alberta’s Peace River area and is run by well-known oilpatch player Don Archibald. “It’s mostly gas production,” says Bay, adding the firm produces about 11,000 boe, but could ramp that up to 13,500 boe in 2008.

Bought two years ago at an average price of $11.50 a share, Cyries stock recently traded at $10, after hitting a high of $15.30 in May 2006. “It could be worth $15 within 12 to 18 months,” says Bay. “This is where the opportunity could lie, provided you’re patient.”

Although commodity prices have stabilized lately, the fact that costs have risen excessively has been a major factor affecting energy stocks, says Laura Lau, senior portfolio manager at Toronto-based Sentry Select Capital Corp. , who helps oversee Sentry Select Canadian Energy Growth Fund.

“Service companies are struggling because utilization rates have dropped substantially,” says Lau, who works with lead manager Glenn MacNeill, Sentry Select’s vice president.

The 25% rise in F&D costs in the past year has clearly hurt margins. “There’s nothing wrong with gas at US$7 per mcf,” Lau says. “The problem is the cost structure is out of control. It’s more difficult to make money.”

@page_break@Yet, from an investment perspective, Lau and MacNeill are more bullish on natural gas than oil. And, like Bay, Lau points to steep output decline rates that are constraining supply. The decline rate is 27% in Canada and 31% in the U.S. In effect, falling output means Canadian natural gas wells must produce more just to stay even.

“Decline rates are getting worse, and pools are getting smaller, but this bodes well for the gas price,” says Lau. Given prevailing trends, natural gas prices could increase 30% to US$9.50 per mcf by November.

On the oil side, she expects crude to stay in the range of US$55-US$65 a barrel, unless there is a geopolitical crisis. “We don’t see it advancing over US$70. At that level, people tend to switch to alternative, cheaper energy sources.”

From a strategic viewpoint, Lau and MacNeill have become more defensive and have pared back their fund’s exposure to royalty trusts to about 25% from 30% at the end of December, with a target of 20%.

“We don’t see a lot of funds flowing into trusts now,” says Lau, adding the caution is because of the so-called “shoulder season,” when commodity prices soften. Conversely, she and MacNeill have raised the fund’s large producers’ allocation to 23% from 20%, increased the intermediate producers to 16% from 14% and boosted the small producers to 20% from 15.8%. The balance is in small holdings in integrated oil firms and service companies, with about 10% in cash.

“We are finding more value outside the trust sector,” says Lau. “Most of the large producers are trading at cheaper valuations.”

One favourite is Canadian Natural Resources Ltd. Primarily an oil producer, the firm is building the Horizon oilsands project, due to come onstream in 2009.

“We don’t think this project has been fully priced in,” says Lau. Investors have focused on the firm’s heavy debt load in its takeover of Anadarko Canada Corp., which is primarily a natural gas producer. But, Lau says, Canadian Natural Resources has negotiated better terms for its debt, which should allay investors’ concerns. Meanwhile, the Horizon project should add 100,000 barrels of daily production on top of the firm’s current 600,000 boe a day. “This should also upgrade the quality of what it sells,” says Lau.

The stock was recently trading at $60.50 a share, but Lau has a target of $72 within 12 months.

On the royalty trust side, Lau likes Vermilion Energy Trust. Unlike most trusts, its assets are overseas in France, Australia and the Netherlands. This means the trust is already being taxed and won’t be much affected by the new rules.

“Its payout ratio is also the lowest in the trust sector, about 40%,” says Lau, adding the firm produced about 27,000 boe a day in 2006. “Even if oil and gas prices drop, it will be the last standing.”

The firm tends to buy properties outside Canada, where they cost less. A core holding, the stock recently traded at $30.30 a share, but Lau has a $35 target within 12 months.



The current market phase may be challenging, but Ari Levy, manager of TD Energy Fund and vice president of Toronto-based TD Asset Management Inc. , is taking a longer-term view. He maintains the fundamentals have not changed.

Basically a stock-picker, Levy also uses a macroeconomic view to shape the fund’s portfolio. “Not a lot has changed in our minds,” says Levy, who works closely with Margot Naudie, vice president at TDAM. “There are bits of anecdotal evidence, pockets of slowdown, but not much. On a global basis, we see growth. China, for instance, is growing well, much of it infrastructure-related. The supply/demand balance for most commodities is fairly strong.

“This is one of those cyclical drops that won’t derail in the long term,” he continues. “This is a very long-term growth process. It will take China decades to industrialize. Over time, it will have superior growth rates on a secular basis. But there may be pockets of several quarters that are not as robust.”

Even the U.S., which has seen signs of slowdown in housing and automotive, is reasonably solid. “The U.S. economy may not be as robust as it once was,” he says, “but it’s made up for by growth in China and other emerging markets.”

Strategically, Levy runs a 50-name portfolio with a heavy concentration of large-cap names, although there is about 25% in small-caps and 15% in income trusts. Among the top 10 stocks, accounting for 56% of the fund, are EnCana, Suncor Energy Inc., Talisman and Western Oil Sands Inc.

“Of companies with the best growth prospects and projects going forward, many, in the past five years, are oilsands-related or large-scale resource plays,” he says. “Their management teams had the ability to bring these projects to fruition. These are long-term investments.”

On the small-cap side, Levy likes junior player ProEx Energy Ltd., a spinoff from Progress Energy Trust, another holding. The share price is down to a recent $12.95 from a high of $16.50 a year ago, but Levy is unperturbed: “It’s doing exactly what it said it would be doing, even beating expectations. It’s the kind of company we like.” IE