Crude oil prices continued to rise in the past year, and reached US$105 a barrel in March as the global economic recovery gathered steam. And although managers of energy funds are placing their bets on oil production, as opposed to natural gas, they remain upbeat about the energy sector’s overall prospects for 2011.
“There was always a risk that crude oil would go through US$100 a barrel,” says Jennifer Stevenson, lead manager of Dynamic Global Energy Class Fund and vice president at Goodman & Co. Investment Counsel Ltd. in Calgary. “Global demand continues to rise at a very rapid pace. It’s mostly coming out of Asia, but we’re also seeing growth coming out of the developed world.”
Stevenson adds that the destabilizing events in the Middle East have resulted in supply disruptions from Libya as well as highlighted the possibility of supply disruptions from other regions: “The disaster in Japan has also raised the possibility of a slowdown in demand from that area.”
In looking at the global supply/demand balance, Stevenson says, crude oil supply sources can offset demand increases for about the next 24 months. “But,” she adds, “the market looks at that and says, ‘Where is the oil coming from once we get through the next 24 months?’ It’s looking into 2012 and 2013 and starting to price in some scarcity.”
However, natural gas prices have been depressed by oversupply. Stevenson says that natural gas prices could pick up in several years as drilling is cut back and less supply comes on board. “I don’t see US$6 [per million cubic feet] gas for a couple of years,” she says. The current price is about US$4.50 mmcf.
A bottom-up stock-picker who had restructured the Dynamic fund when she assumed its management in August 2010, Stevenson is running a concentrated portfolio of 40 names. “[The fund] is more weighted to Canada, in some companies that have great oil-focused drilling programs,” she says, noting that about 70% of the fund’s assets under management is in Canadian firms and the remainder in U.S. and international players.
One favourite holding is Surge Energy Inc. This small-cap firm is run by a team that formerly managed Breaker Energy Ltd. Surge is developing Alberta’s Valhalla play, which produces about 5,000 barrels of oil equivalent a day. “I’m investing with people I know,” says Stevenson. “They did the same thing at Breaker: bought assets from a major company, which had not been looked at, and used horizontal wells to increase production. It’s a high-quality team, and a high-quality asset.”
Surge’s stock is trading at about $8.45 a share. Stevenson has a 12-month target of $10.
Stevenson also likes Talisman Energy Inc. The senior oil and gas producer, which is active in Southeast Asia and North America, was trading at a discount to its large-cap peers when the Dynamic fund bought into it this past autumn. “It had a management change and brought in a new strategy,” Stevenson says. “The market’s been waiting to see if it will play out — and it has. The results have been coming through.”
Talisman’s stock is trading at about $22 a share; Stevenson’s 12-month target is $26.
Equally Bullish Is Eric Nuttall, manager of Sprott Energy Fund, and portfolio manager with Toronto-based Sprott Asset Management LP “It’s going to be another good year. The backdrop of a very strong oil price is going to allow some very good investment returns.”
One of the chief drivers of the price of oil has been increasing global consumption. Although the 2007-08 recession saw global consumption drop to 84.3 million barrels a day from 88 million, it has since rebounded to 88.5 million barrels. “This year, it’s expected to hit 89 million barrels,” says Nuttall. “Demand is very strong.”
Moreover, supplies from non-OPEC producers, which account for about 60% of global oil production, peaked in 2010 and are expected to decline this year. “In short, supply is not keeping up with demand,” says Nuttall. “The market is undersupplied by 900,000 barrels a day, which is coming from OPEC’s spare capacity.”
Nuttall reckons that strong demand will keep crude oil in the US$90 per barrel range, or about 10% higher than it ought to be. “At US$80-US$90,” he says, “the crude oil business in Canada is phenomenally profitable. That’s why I’m 84% weighted toward oil.”
Currently, Nuttall is favouring a mixture of small-cap and mid-cap oil producers within the Sprott fund: “They’re trading at attractive multiples but also have meaningful upside, based on exploration or delineation of a new resource.”
A bear on natural gas for the past year, Nuttall continues to be bearish — largely because of the vast oversupply: “Current gas prices are unsustainable, and the price will go lower.”@page_break@Nuttall, who assumed management of the entire portfolio in November after sharing management duties with Sprott CEO Eric Sprott, is running a tight list of 40 names in the fund, plus one short position. (Up to 20% of the fund’s AUM can be in short positions.)
One top name is WestFire Energy Ltd., which is active in Al-berta and Saskatchewan. “It’s trading at seven times enterprise value to cash flow,” says Nuttall, noting that its peers trade at seven to nine times. “The company is involved in the Viking play, a reservoir that is not fully appreciated by the market. But that’s changing in the coming months.”
WestFire’s stock is trading at about $8 a share. Nuttall believes the firm is a takeout candidate and could be bought out within two years at $15 a share.
Another favourite is Painted Pony Petroleum Ltd., which produces a 45%/55% mix of oil and natural gas. The firm is involved in Saskatchewan’s Bakken play and has an eight-year inventory of oil production. “It also has significant land in British Columbia’s Montney natural gas play,” says Nuttall. “It’s wrong to assume gas is not profitable, because this project is very profitable. The wells are so prolific and the new royalty incentives greatly help.”
Nuttall believes Painted Pony’s current share price of $10.35 has room to rise: “There’s more than 50% upside. But it’s also a strong takeover candidate, and a buyer could easily pay $15 a share.”
The Global Economic Rebound has been a key factor in the rising oil price, says Ari Levy, vice president and director with Toronto-based TD Asset Management Inc. and lead manager of TD Energy Fund. “People are talking about 4%-4.5% [gross domestic product] growth on a global basis. Historically, over the past 20 years, growth has ranged from 2% to 4%. Only in 2008, it went below that range,” he says. “To the extent the growth is at the top end of the range, or even exceeding it, the market looks at that as a positive factor. You can’t fuel economic growth without an increase in consumption.”
Oil consumption did drop in the U.S. in the recession, “but it never dropped more than 5%-6%,” says Levy. “On the flip side, China and other developing economies picked up the slack. There has been a recovery in the developed world, but it’s the developing world that is driving the bus. It’s more than willing to step in and benefit from a decline in commodities prices when mature economies hit the brakes.”
A bottom-up investor running a fund with about 70 names, Levy shares duties with Chad Gilfallen, TDAM vice president. Lately, the TD fund has increased its foreign holdings so that about one-third of its AUM is in international companies; that exposure is protected by currency hedging.
One long-term U.S. holding is Chevron Corp. “It’s considered at the bottom end of the super-majors,” says Levy. “Some call it a super-regional, but we think it has global heft.”
Several years ago, he adds, Chevron began focusing more on upstream operations and increasing return on capital. As a result, the firm sold off assets and reduced costs, and now boasts a 17% return on equity, vs 15% for its peers. Chevron has production growth of about 3%, almost double the average of its top five global peers.
Chevron’s stock is trading at about US$96.65, or a multiple of 10 times 2012 earnings. It also pays a 3% dividend. Levy has no stated target.
Levy also likes Cenovus Energy Inc., an oil-production firm spun off by EnCana Corp. in 2009 that now produces about 60,000 barrels of oil equivalent a day. It also owns natural gas reserves that are used to produce oil from the Alberta oilsands. “By allocating these low-cost mature assets to Cenovus,” says Levy, “[EnCana] gave the company a head start and allowed it to focus its capital on the oilsands business.”
Although Cenovus’s stock is expensive, Levy believes the price/earnings multiple will shrink: “The build-out of [its] oilsands business over time will be substantial. As [it] grows [its] net asset value in line with [its] plans, production will ramp up, and the valuation should normalize over time.”
Cenovus’s stock is trading at about $33.80 a share. IE
Managers bank on demand for black gold
Strong oil prices will create some good investment returns. “It’s going to be another good year,” says one energy fund manager
- By: Michael Ryval
- April 4, 2011 October 30, 2019
- 14:05