Sector Watch: Have oil price shocks come to an end?

“[The decline] happened so quickly that it’s hard to calculate the fundamentals behind it,” he says. “If your supply and demand are out of sync, people don’t just wake up one day and say, ‘We have more supply and less demand, let’s crap out the price.’ This tells you there are other factors playing into the price that don’t give you a proper understanding of the fundamentals. That’s typically because of derivatives traders and (investors with) long positions and short ones that tend to oversell or overbuy the commodity.”

For now, Tahmazian is cautious and waiting for the market to stop punishing the energy sector: “All of the oil and gas stocks have become ‘have nots’. There’s no differentiation between the good and bad companies. Even some companies that are good have been caught off guard by the correction. You need to take time to understand how it all works.”

Tahmazian argues that oil prices eventually will recover, although he’s uncertain about the timing. He also notes that some companies with projects based on crude trading at US$85 a barrel are very vulnerable because these projects can be completed only if costs are reduced significantly.

“So, instead of asking, ‘Will the oil price recover?’ we ask, ‘Which companies are healthy and can grow in this environment and buy assets cheaper, benefit from service costs coming down and actually make money at US$60-US$70 [a barrel] – because they paid so much less and costs have fallen?’ That [distinction] will develop over time.”

Tahmazian has been cautious since last autumn, when he began raising the level of cash held in the Canoe fund; cash now represents more than 40% of the fund’s assets under management (AUM). The fund also holds about 10% in U.S.-dollar bonds issued by Canadian energy companies and 10% in large U.S.-based energy producers.

Running a fund with about 15 holdings, Tahmazian likes firms such as Cardinal Energy Ltd., which produces about 11,000 barrels of oil equivalent (BOE) in Alberta and Saskatchewan. Taking into account Cardinal Energy’s 70% payout ratio, Tahmazian notes, that leaves the firm with 30% of its cash flow to pay down its debt. “That’s a very healthy situation and they can look for opportunities to buy more assets,” he says.

Cardinal Energy stock trades at about $14.50 a share and has a 5.6% distribution yield. There is no stated target.

Picking the bottom – or top – of a commodity’s price is a mug’s game, argues Les Stelmach, vice president with Calgary-based Franklin Bissett Investment Management Ltd., and portfolio co-manager of Franklin Bissett Energy Corporate Class Fund. He shares portfolio-management duties with Garey Aitken, chief investment officer at Franklin Bissett.

What is clear, however, “whether it’s US$44 a barrel, US$49 or US$55, that price is not sustainable,” says Stelmach. “We’re not suffering a demand ‘shock.’ In fact, we’re seeing some increased demand, due to lower prices. What we have now is a reckoning, where supply growth has outpaced demand growth for some time. It’s not a large gap; it’s about one to two million barrels a day of excess supply, or 1%-2% above demand.”

In the short term, the crude oil price will fluctuate due to myriad factors. Longer term, Stelmach argues, the price will rise to match economic reality, “which is a lot higher than, say, US$50. In a downturn, companies will get more efficient and trim the fat. We’re not forecasters; yet, looking at all the companies we follow, [we believe] crude prices are not sustainable at these levels because there isn’t sufficient profit to reinvest in drilling new wells and bring new production onstream to offset growth in demand. Prices will have to rise.”

One factor in getting the price back up again is reduced capital spending, he says: “A number of companies have cut capital spending, and they are significant cuts.”

Yet, Stelmach cautions, it will take time for the impact of the spending cuts to be reflected in oil prices: “Prices could stay down here for months. That’s why it’s dangerous to make forecasts. That’s why companies are cautious with their spending plans.”

As for valuations, Stelmach argues that energy stocks are generally attractive: “If you assume a return to more ‘normalized’ prices – anything north of US$75 a barrel – the sector looks very cheap.”

The fully invested Franklin Bissett fund holds 40 to 55 names. About 55% of AUM is in oil and gas producers, 35% is in oil services companies and 10% is in pipelines.

One favourite name, which reflects the fund’s bias toward smaller producers, is Crew Energy Inc., which produces about 21,000 BOE in British Columbia and Alberta. Crew has sold off some assets and concentrated its efforts on developing the so-called Montney formation. “[Crew] is a low-cost producer and has the most competitive natural gas production in North America,” says Stelmach.

Crew stock is trading at about $5.80 a share, although Stelmach believes it’s trading at about a 50% discount to its intrinsic value. There’s no stated target.

One portfolio manager who believes that the crude price is reaching bottom is Thomas George, vice president with Toronto-based TD Asset Management Inc. and portfolio manager of TD Energy Fund. This view is based on the notion that the oil industry must go through a so-called “good sweating” before it can move forward.

“That was the strategy used by John D. Rockefeller [who ran Standard Oil Co. Inc. in the 1870s] to deal with competitors,” George says. “Whenever he wanted to buy competitors and they didn’t want to sell, he’d ‘sweat’ them out.”

In George’s view, OPEC is taking the same approach. “They’re effectively trying to mute, or kill, the growth that’s come from U.S. shale, the oilsands and ultra-deep offshore wells. That needs to happen – to wash the system of all these marginal barrels of oil when the price was US$90 [a barrel].”

At US$45 a barrel, he adds, the North American oil industry is stressed because it is operating close to the cash cost of production: “The weaker guys have to rethink the barrels they are producing at a negative profit; this is really hitting the bottom line. But we are very close to flushing out enough supply in the market that we will start to see some rebalancing. It’s fair to say that we will come to that point in the next three to six months.”

George expects that the crude oil price might be US$65-US$75 a barrel in about six months.

Given where the crude price is now, George believes that many stocks are trading at 1.1 to 1.2 times their net asset values: “These stocks are attractive. When we get through this ‘valley,’ we will see these stocks higher in aggregate.”

About 4% of the TD fund’s AUM is in cash, 66% is in Canadian stocks and 30% is in the U.S. Referring to the U.S. holdings, he says, “That’s a function of where we see bottom-up value.”

In terms of industries, there is 48% in exploration and production firms, 18% in pipelines, 16% in integrated oil companies, 4% in refiners and smaller weightings in industries such as drilling and equipment services.

A top holding in the 50-name TD fund’s portfolio is EOG Resources Inc., a U.S.-based shale oil producer with daily output of 600,000 BOE. “[EOG] is one of highest-quality U.S. E&P [exploration and production] companies, period,” says George, noting that EOG, a potential takeover candidate, is active in the Bakken, Permian and Eagleford shale oil plays.

“{EOG] is a company has translated its superior technical ability to identifying the sweetest spots in each one of these plays,”George adds. “Combine that with the lowest quartile of leverage in the U.S. E&P universe, it’s a company that delivers what oil and gas companies should.”

EOG stock is trading at about US$93.20 ($116.50) a share. George has a 12- to 18-month target of US$102 a share.

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