Although crude oil prices have hit a record high, nearing US$110 a barrel, and natural gas prices have stabilized at around US$10 a million cubic feet, it’s cold comfort for an energy sector that has languished for the past two years. Yet fund managers argue that, perhaps, the worst is past, as the impact of a host of negative factors begins to dissipate.

“We’ve come through a period in which natural gas prices had dipped on the perception of ample inventory levels,” says Ari Levy, lead manager of TD Energy Fund and vice president of Toronto-based TD Asset Management Inc.

Indeed, the past two years has been marked by a spate of bad news. For example, the market for many oil and gas income trusts surged until Halloween 2006, when federal Finance Minister Jim Flaherty stunned the industry and changed the tax treatment of the trusts. Prices of many income trusts were hammered as a result.

This past fall’s new royalty measures in Alberta created similar shocks. “The increase in royalties out of Alberta has changed companies’ spending priorities,” says Levy. “Investment focused on the gas side has been de-emphasized and people have put more money into Saskatchewan and B.C. and the U.S. Rockies. These discrete events have had an influence on the performance of stocks and the sector as a whole.”

To top it all, the price of crude oil has sky-rocketed, largely on speculation. “The market does not believe in the sustainability of the commodity price,” he says. Indeed, he notes, price increases have been greeted with concern as energy producers are feeling growing cost pressures as other stakeholders want their share of the bounty.

Levy admits it is difficult to predict what lies ahead, especially when it comes to political and taxation policy changes. “My focus is on looking at what are the sustainable margins in the business. I think we are at a good time. We may even be at a bit of an inflection point.”

On the natural gas side, for instance, prices have rebounded and seem to have stabilized as service companies are less aggressive in demanding higher fees.

“You will see increased activity,” he says. “But cooler heads will prevail. I am cautiously optimistic.”

Strategically, Levy is running a 50-name fund that is concentrated; the top 15 companies account for two-thirds of the portfolio. There is also a large-cap focus and a bias toward companies such as EnCana Corp., Suncor Energy Inc. and Husky Energy Inc. that have large-scale growth projects that can be funded out of cash flow. “We are looking at those who have a focus on cost-containment and the ability to drive lower costs over the longer term,” says Levy, adding that the majority have operations around the world.

The fund also has about 25% in small-caps, 12% in income trusts and 10% in cash.

One of the top holdings is Talisman Energy Inc. “It’s well-balanced and has around one-third of its assets in Canada, roughly one-third in Norway and the North Sea and the rest is in places such as Vietnam and Indonesia,” says Levy.

But the market is impatient about the direction the company may take as the firm’s new CEO, John Manzoni, who assumed the post from Jim Buckee this past September, has yet to announce any strategic changes. “He’s taken a prudent approach,” says Levy. “I don’t expect a replication of Jim Buckee’s strategy. There will be material changes, but it will be with a view to profitable growth and where the company can best deploy its assets.” Levy says Alaska represents one exciting prospect which the firm is expected to develop.

“We’re patient investors and are willing to wait,” he says. A long-time holding, the stock was recently trading at $17.25 a share. Levy has no stated target.

On the income trust side, Levy likes Vermillion Energy Trust. Although many trusts have talked about international diversification, he says, “very few have made any material international investments and Vermillion is one of them.” The company has operations in France, Trinidad and Norway.

“It’s been opportunistic and enhanced its growth profile and lowered its cost structure,” he adds. A long-term holding, it was recently trading at $37.45 a share.

The sector has been hurt by a string of negative factors, including perhaps the most damaging, the Halloween “massacre” of October 2006, says Craig Porter, manager of CIBC Energy Fund and vice president at Front Street Capital Inc. in Toronto. Income trusts lost their high-multiple premiums and effectively ceased to be acquirers, thus depressing the prices of many potential acquisitions in the form of junior stocks.

@page_break@“This past fall, there was another knock against the industry when the Alberta government announced it would increase royalties quite dramatically — some were going up 25% or more,” he says. “Plus, on the cost side, things were getting out of hand. Some companies even stopped drilling. That’s how bad it was.”

Conditions are starting to improve, however. “In Canada, gas prices have come up. And service costs have started to come down, as fewer companies are drilling,” says Porter. “Companies can get good rates and projects are being drilled in a timely manner. And land prices have come down. All of a sudden, there’s a lot less competition. We are starting to see that things look a little better.”

As for the sky-high oil price, Porter says that much of the rapid increase in recent months has been driven by speculators and the falling U.S. dollar. “The oil price has run too fast. Long term, it could fall back to US$75-US$80. But it could be in the range of US$80-US$100 a barrel for a long time. The rest of the world is consuming at a dramatic pace and it’s not feeling the effect of US$105 oil, because their currencies are up against the US$.”

Porter maintains there is strong demand for oil globally at US$105 a barrel. The only country to feel the full effect is the U.S. because its weak currency. Of course, oil could go higher, as there are many geo-political uncertainties, but those are very difficult to forecast.

Porter has become more defensive and raised cash to about 6% of the fund’s assets under management because he is concerned that the crude oil price is in a bubble-like phase. He runs a 40-name fund that is roughly split between junior exploration plays and intermediate and senior producers.

One of his favorite names is Duvernay Oil Corp. The mid-cap natural gas explorer and producer is managed by executives who previously operated Berkley Petroleum Corp. It has also benefitted from the fact it’s largely active in B.C., avoiding the controversial Alberta royalty issue.

“It’ has a massive inventory of drilling prospects,” says Porter. The firm is producing 26,000 barrels of oil equivalent (BOE) a day, but by 2011, output will almost double. In addition, it stands to gain in a big way from the Montney play in B.C., which has attracted other firms, as well. “It doesn’t have to buy other companies [to grow]. It has the assets in hand,” he adds. Bought in late 2005 at around $38 a share, the stock was recently unchanged. Porter has no stated price target.

Another mid-cap favorite is Petrobank Energy and Resources Ltd. The firm has developed a technology that mines the oil sands in a much more efficient way than conventional methods, which burn huge amounts of natural gas to extract the oil. Petrobank’s patented technology creates a kind of “fire-front” underground that heats up the bitumen so that it can flow more easily and rise to the surface. It also produces far fewer greenhouse gases.

“Longer term, the company wants to go into other oil sand properties and get either a royalty or part ownership to bring the technology to assets which might otherwise be uneconomic,” says Porter. “Capital costs on these projects have been rising dramatically. If you have a way to bring down the operating costs — because steel and labour costs are going up and out of your control — it makes the project far more economical.”

Bought about 18 months ago, when the stock was $18 a share, it recently traded at $49.75 a share.



It’s time to be a little more defensive, argues Glenn MacNeill, manager of Sentry Select Canadian Energy Growth Fund and vice president at Toronto-based Sentry Select Capital Corp. “We’ve been using some of these rallies to reduce our positions in several companies,” he says, noting that most of the players in the Western Canadian sedimentary basin are heavily weighted to natural gas production. “Gas prices are having a good run now. But they could get soft going forward. As we go into the summer months, gas could weaken into the US$6-US$7 a million cubic fee range.”

Besides raising cash to around 10% of the fund, MacNeill is gradually reducing the funds’ income trust exposure to 20% from more than 24% of AUM. “Many trusts were overpriced,” he says. “Now valuations are in line with the stocks.” There is also 13% in international plays, 22% in junior oils, 12% in mid-caps, 12% in large-caps, 4% in oil transportation and 3% in integrated companies.

One of his favorite stocks in the 30-name fund is Ithaca Energy Inc., a mid-cap exploration firm that MacNeill categorizes as part of the international exposure. Active in the North Sea, Ithaca will start producing 7,000 BOE a day in 2009 and double that output in 2010.

“We like what we see,” he says. “Smaller companies have been able to succeed in the North Sea, where the larger players have bowed out. Ithaca is more nimble, and able to do things quicker and faster. It has good growth prospects and we believe it will do well.”

Bought this past summer, the stock recently traded at $3.10 a share. MacNeill’s 12-18 month target is $5 a share.

Among the juniors, MacNeill likes Vero Energy Inc. Primarily a natural gas producer, Vero has operations in west-central and northern Alberta, and is expected to produce 6,500 BOE a day in 2008 and 7,000 BOE next year. “It has a good management team and it’s done a good job in proving up the reserves,” he says. Vero is the result of the November 2005 merger between True Energy Inc. and TKE Energy Trust. “We like what we see out there.”

The stock recently traded at $7.60 a share; MacNeill’s target is around $10 a share. IE