Sector Watch: Global view taken within energy funds

A few Canadian energy funds lead the category by picking their spots within the sector. Generally, the better-performing funds have been treading lightly among companies focused on Canadian oil and gas operations; rather, these funds have found richer opportunities in the U.S. and Europe.

The Canadian oil and gas industry is plagued by a sizable price disadvantage applied to its heavy oil. Western Canadian select, the main grade of oil extracted by Canadian oilsands producers, is trading around US$30 a barrel less than WTI, the widest discount in almost four years. Pipeline delays and transportation bottlenecks in other areas, such as rail, also conspire to stifle the Canadian industry.

There have been delays for all three major proposed oil pipelines to export more oil from Western Canada, including Kinder Morgan Inc.’s Trans Mountain expansion, Enbridge Inc.’s Line 3 replacement and TransCanada Corp.’s Keystone XL pipeline.

Meanwhile, the U.S. shale-oil industry is ramping up production as companies jump to take advantage of WTI prices that are significantly higher than the US$42-a-barrel range at which they traded as recently as mid-2017. Large multinationals and medium-sized producers that became more cost-efficient in leaner times are seeing the benefits flow through to their bottom lines.

Rafi Tahmazian, senior portfolio manager and director with Calgary-based Canoe Financial LP and manager of the Canoe Energy Class Fund, is among those portfolio managers who has achieved category-beating returns by de-emphasizing Canada.

“Government policies have destroyed foreign capital investment in Canada,” Tahmazian says. “Stocks that used to trade at a premium to those in the U.S. have become illiquid. There is lack of clarity and a lot of uncertainty, and no incentive for foreign investors to commit capital.”

Tahmazian says that alarmingly little attention is being paid by Canadian governments to eliminate the problem of increased oil and gas production coming onstream without a matching increase in pipeline and other transportation capacity such as rail.

“It’s simple math, and if the government is not doing the math, that’s unacceptable,” Tahmazian says. “If it is doing the math and not fixing the problem, that’s dangerous. The time [required] to bring on the needed infrastructure will be long. [The disparity] is an intermediate [timeline] problem and won’t go away this cycle.”

South of the border, U.S.-based energy companies have been encouraged by President Donald Trump’s tax cuts as well as by plans to increase infrastructure spending and streamline the ability to get projects approved.

At the same time, global economic growth is strong, an encouraging trend on the demand side for energy companies that can access the market. On the supply side, members of the Organization of Petroleum Exporting Countries (OPEC) and other producing countries have been cutting production since early 2017 to force global inventories lower and support prices. Although this restraint has borne fruit in pushing up the price, the strategy’s success has encouraged U.S. producers to ramp up operations, particularly on the shale side.

According to the U.S. Energy Information Administration, the U.S. is pushing out between 10 million and 11 million barrels per day (bpd) this year, moving production levels into close range with that of Saudi Arabia, OPEC’s biggest producer, and with Russia, the global leader in 2017 with about 11 million bpd.

U.S. production has jumped by almost 80% in the past six years, as drilling techniques originally used to release natural gas from shale have been adopted by oil explorers. The U.S., traditionally the largest consumer of Canadian oil, may soon become an energy exporter.

Portfolio managers of funds in the sector are constrained by the limitations of their mandates and must find ways to maximize returns within their permitted investment sphere. Tahmazian makes sectoral calls within the Canoe fund as conditions change, and also strategically increases or decreases the fund’s cash position to maximize returns or add a layer of downside protection. The fund’s cash allocation has been as high as 75% in the past, although the fund is fully invested at present.

“We take a subsector and geographical approach,” Tahmazian says. “When I like a subsector, I buy [shares in] all the best companies in that industry. We know our favourite companies, and we ride the sector. It’s about when you buy the stocks and when you sell. They all get thrown out with the bathwater when sector [prices] go down.”

Currently, 30% of the Canoe fund’s assets under management (AUM) is invested outside of Canada, primarily in the U.S.; 30% is held in Canada-domiciled companies with attractive U.S. properties; another 30% is held in “pure Canadian holdings” that have superior businesses; and 10% is held in private equity. (The fund’s largest private holding is Certarus Ltd., a Calgary-based company involved in the transportation of compressed natural gas to remote operations.)

There also are opportunities to invest in renewable alternatives and innovative technologies in storage, clean oil and carbon emission reduction, Tahmazian adds.

In Canada, Tahmazian prefers companies with exposure to light oil and condensates, which fetch better prices than heavy oil. Among the Canoe fund’s top holdings is Paramount Resources Ltd., which has properties in Western Canada’s promising Montney and Duvernay formations and was bolstered by the acquisition of Apache Canada Ltd. last year.

Tahmazian is “building a position” in Seven Generations Energy Ltd., which operates in the Montney field.

Tahmazian also likes the outlook for services companies, particularly “frackers and pumpers” with exposure to the U.S. shale business. Top holdings in the Canoe fund in that industry include STEP Energy Services Ltd. and Calfrac Well Services Ltd.

Tahmazian foresees long-term potential for liquified natural gas (LNG), and many of the Canoe fund’s foreign holdings have interests in the LNG business.

The Canoe fund has some exposure through “super majors,” such as Netherlands-based Royal Dutch Shell PLC and U.K.-based BP PLC, as well as lesser-known companies. Among the latter, the Canoe fund holds shares in U.S.-based Cheniere Energy Inc., which is involved in LNG terminals and transportation, and has a supply contract with China. Another holding is Calgary-based Pieridae Energy Ltd., a fully integrated LNG company developing a terminal in Nova Scotia.

“Liquified natural gas is an intriguing industry,” Tahmazian says. “It’s the link between oil and non-oil energy. The time you want to build exposure is when nobody is looking at [the industry].”

Greg Gipson, managing director with BMO Asset Management Inc. in Toronto and portfolio manager of BMO Global Energy Fund, also is happy that the world is his oyster when he seeks energy opportunities.

Less than 10% of the BMO fund’s AUM is invested in Canadian companies. Gipson is focused abroad, with about 46% of the BMO fund’s asset allocation held in U.S. equities, 20% held in Europe and 11% held in the U.K., with smaller holdings in Asia, Japan and Australia.

“[Energy production in] Canada faces a number of constraints, including the heavy oil differential and the ability to move product,” Gipson says. “The world is a large and wonderful place, and right now there are more attractive opportunities outside Canada.”

With global demand healthy, Gipson increased the BMO fund’s positions in integrated multinational giants such as Royal Dutch Shell, U.S.-based Chevron Corp. and Austria-based OMV AG.

Top holdings in the BMO fund also include refining and marketing operators Valero Energy Corp. and Marathon Petroleum Corp. of the U.S., and Neste Oyj of Finland. Gipson points out that U.S.-based companies will see their profits beefed up by the double benefit of U.S. tax reform and strong economic growth.

“The larger refiners are seeing the results of cost-cutting and healthier oil prices,” Gipson says. “During the past few years, companies have restructured, become more cost-efficient and improved their balance sheets. And US$60 [a barrel] oil, therefore, looks better than it did a few years ago.”

One of the few Canadian holdings in the BMO fund is Suncor Energy Inc., which focuses on the production of synthetic crude from the Alberta oilsands and, despite some of the pricing issues faced by heavy oil, has strong free cash flow.

Gipson is less optimistic about natural gas. He says a significant amount of associated gas from U.S. shale development is flooding the market.

About 11% of the BMO fund is invested in service companies, a diversification strategy that Gipson views as defensive.

A key holding in that industry is TGS NOPEC Geophysical Co. ASA of Norway, which provides geoscientific data to assist energy companies around the world with exploration and production.