Faced with dramatically lower prices for crude oil and natural gas, many energy companies have been cutting distributions or shelving new projects. That environment has left managers of energy funds divided over how to work through this rough patch. Some are being cautious and holding cash; others are staying the course, despite the poor near-term outlook.

One of those on the cautious side is Scott Vali, manager of CI Signature Global Energy Corporate Class and vice president of Signature Global Advisors, a unit of Toronto-based CI Investments Inc.

“There is a risk that oil could see a lower price,” says Vali, who sees the price of oil fluctuating between US$40 and US$60 a barrel in the near term. “On current oil prices, it’s not economical to invest for future production. Returns won’t be there.”

Without investment, he argues, production will decline, effectively correcting the oversupply in today’s market.

“The key is that investment in future production is falling, which is actually bullish for oil, longer term,” he adds. “If prices fall further, you will see a lack of investment. That will be problematic for future supply. When the economy does move out of the recession, supply won’t be there to meet demand and prices could start to move quite a bit higher. The outlook further on is actually positive.”

Of course, increased demand depends on an economic rebound — and stimulus packages in China and the U.S. are having an impact. “[Those packages] are starting to get some traction,” Vali says. “We are also seeing credit markets free up. As we move forward, we will get a better feel for where real demand is. The level of pessimism in the market at the end of 2008 was probably overblown. Question is: where do we start to see things improve? We don’t have clear answers yet, but we’re hopeful that we’re moving forward.”

About 21% of the CI fund’s $113.2 million in assets under management is in cash; the remaining AUM is dominated by energy stocks.

“In the near term, we are cautious,” says Vali. “There is an oversupply of gas in North America. But as we move away from the heating season, prices will probably move lower, which will have an impact on producers. We’re hopeful there will be an opportunity to buy some gas and oil companies at lower prices. We are waiting for an entry point.”

Running a 45-name portfolio, Vali favours large-cap producers that have low-cost production and strong balance sheets, enabling them to survive a period of low commodity prices. Constrained credit and equities markets make it very difficult for smaller firms to survive. “Most small-cap producers in Canada are gas-focused,” he adds. “Our outlook for gas is that things could move lower.”

Vali does favour a few better capitalized small-cap names, however, including Storm Exploration Inc., a natural gas producer active in the Monteney region of British Columbia. “There have been some fairly encouraging finds in that area,” says Vali. “Storm Exploration is positioned as a fairly low-cost producer.”

The CI fund bought Storm Exploration shares about a year ago at about $12 each; they recently traded at $9.90 a share. “It’s not the cheapest name,” Vali says. “But there is a differentiation in the market between players that have opportunities to move forward and those that are distressed.”

Vali has no stated price target for the Storm Exploration shares.

On the large-cap side, Vali likes San Ramon, Calif.-based Chevron Corp., one of the world’s largest integrated oil and gas companies. “It has a good balance sheet and growth opportunities,” he says. “It’s a bit more on the safety side in this environment, an investment that allows you to participate in the commodity cycle without worrying that it will lack the financial capacity to survive.”

A long-term holding, Chevron was recently trading at US$58.50 a share.



Equally cautious is Mason Granger, portfolio manager with Toronto-based Sentry Select Capital Corp. and co-manager of Sentry Select Canadian Energy Growth Fund.

“A lot of the holdings in the portfolio speak to the amount of caution we are using in this environment,” says Granger, who runs the fund with Laura Lau, senior portfolio manager with Sentry. Granger has been defensive since last summer, when he took over the fund’s management from Glenn McNeill.

@page_break@About 25% of the Sentry fund’s AUM is in cash. The remainder is in oil and gas royalty trusts (21% of AUM), integrated oil companies (11%), international oil and gas (6%), large exploration firms (10%), intermediate-sized exploration firms (13%) and junior oil and gas companies (14%).

“What differentiates this commodity cycle from other cycles is the financial crisis that is overlaid on it,” says Granger. “This is a bank-led recession, which tend to be longer and deeper. We had the bursting of several bubbles — the U.S. real estate bubble, a commodity bubble and a credit bubble — all at the same time.”

With oil prices at about US$47 a barrel, much of the energy industry is struggling to make money. “The economics of the marginal barrel is more than the current price of oil,” says Granger, arguing that the marginal cost should be based on extracting oil from the Canadian oilsands. “For steam-assisted gravity drainage technology, those projects require an oil price in excess of US$70 a barrel. Because of the capital intensity, a greenfield [start-up] integrated mining and upgrading oilsands project needs a price in excess of US$100 a barrel.”

Granger expects the oil price to stay in a narrow range, based on several factors. First, demand for gasoline in the U.S. has dropped significantly. Second, although India and China are growing consumers of oil and gas, it’s uncertain how the global economic slowdown will affect their energy consumption. Third, based on the slow response by the Organization of Petroleum Exporting Countries to cut its production quotas, Granger expects the oil price to bottom at the end of 2009.

“Finding a bottom might be coincident with seeing some signs that the global recession is behind us,” he says. “In the interim, oil could be range-bound. At some point, it will be an opportunity to migrate to companies with more torque in a rising market. But we’re not there yet.”

As a consequence, he is sticking to larger companies with strong balance sheets, solid cost structures and low debt. Among the 30 names in the Sentry fund’s portfolio is Imperial Oil Ltd., a major — debt-free — oil refiner.

“It has some of the highest-quality resources, particularly in Cold Lake, and the Kearl and Syncrude [oilsands projects],” says Granger. “Imperial Oil is very disciplined in allocating capital. It has the best track record of creating shareholder value.” Since 1995, Imperial Oil has returned 60% of its cash flow to shareholders through share buybacks.

A core holding in the Sentry fund, Imperial Oil shares were recently trading at $40.25 a share, vs $62 a share last July. Granger has no stated target.

Another favourite is Husky Energy Inc. Like Imperial Oil, Husky has a solid track record and is debt-free. “Husky has fairly substantial access to credit,” Granger says. “We like the fact that the balance sheet is solid and flexible.”

Imperial Oil’s stock was recently trading at $26 a share vs $54 a share last June, and boasts a 4.2% dividend yield.



Although the commodity market has taken a more severe beating than many expected, Ari Levy, manager of TD Energy Fund and vice president of Toronto-based TD Asset Management Inc. , remains fully invested and is confident of a turnaround.

Levy argues that the strategy that worked for the TD fund in the past will work in the future: “The focus has always been on larger-cap companies that have growth projects that they can execute over time through internally generated cash flow.”

The TD fund is diversified geographically, with about 57% of AUM invested in Canadian stocks and 22% in U.S. companies. Another 13% of AUM is in income trusts with 5% in cash and smaller holdings in international names.

“You have to maintain a focus on companies that can, over the longer term, add barrels at low cost, and have a proven track record,” Levy says. “That’s not something you want to deviate from, even when times get tough.”

About 75% of the TD fund’s AUM is in large-caps, with the balance in small-cap and intermediate-sized firms. The top holding in the 50-name portfolio is EnCana Corp., which has two joint ventures in the oilsands sector.

“We’ve always liked it. It is among the lowest-cost producers of gas,” says Levy. “It has strong management and a tremendous hedging program that has been a very successful component of its overall strategy. That has allowed it to expand and avoid some of the discounts other companies are seeing — and helped protect its cash flow.”

A long-term holding, EnCana’s stock recently traded $48.90 a share, vs its $95-a-share high last July. Levy has no stated price target.

On the small-cap side, Levy continues to like Progress Energy Resources Corp., even though its stock is trading around $9.50 a share. Progress Energy was formed in January 2009 by the merger of Progress Energy Trust and ProEx Energy Ltd. A natural gas producer, the firm is primarily active in northeastern B.C.

“It got rid of a lot of properties that did not fit its profile,” says Levy, noting that the management team has been in place since the days it operated as a trust.

“It’s refreshing to see a company that really knows its strengths and modifies its strategy accordingly. Long term, if you are bullish on the gas story from B.C., this is a name that should be a core portion of the portfolio,” says Levy. IE