Full episode: Market Call for Thursday, March 15, 2018
Eric Nuttall, partner and senior portfolio manager at Ninepoint Partners
Focus: Energy stocks
How can one of the most lucrative investment opportunities in decades stare investors in the face and yet, month after month, energy stocks continue to languish? While the market’s focus stubbornly remains on other areas like bitcoin, marijuana stocks and the general tech space, the energy sector is getting unintentionally shunned.
Media outlets give significantly more airtime to discussing in-vogue names like Amazon or Canopy Growth than the $2.3-trillion oil market or the energy stocks, which have dislocated from the price of oil by the greatest extent in history as crude trades at multi-year highs. Oil spot/strip price in Canadian dollar terms is up 14 per cent/6 per cent since the beginning of 2017 and many Canadian oil stocks are down 50 to 60 per cent over the same time frame: More than 65 per cent relative underperformance.
What makes this lack of interest (and commensurate lack of investment flow) so frustrating? It's because the current macro backdrop for oil is overwhelmingly positive in addition to our belief that crude is in a multi-year bull market with few things capable of interrupting this reality. Why can’t everyone see what we see?:
- Oil is trading near a four-year high.
- The “oil glut” (that is, OECD surplus oil inventories to the rolling five-year average) has fallen from 334 million barrels as of January 2017 to a now about 26-million-barrel deficit. This number could swell to a deficit of more than 300 million barrels by the end of 2018.
- OPEC and Russia have pledged that their 1.2 million barrels per day (bbl/d) cut will continue throughout 2018 and their compliance to the cut has been impressively strong, consistently exceeding 100 per cent. Even if they’re lying and all of the shut-in production were to come online today, the market would be back to an undersupplied scenario by the end of 2018 (this is not well understood).
- Oil demand is rocking, with 2017 demand up about 1.7 million barrels per day and 2018 looking to be an even stronger year. Some firms like Goldman Sachs calling for growth to exceed 2 million bbl/d.
- The big boogeyman in the room, U.S. shale, will not grow as quickly as people believe and will be limited to about 1.2 million bbl/d. This is due to an incredibly important and yet still underappreciated shift in management mindset (and incentive plans, with 60 to 70 per cent of companies adopting a returns-based incentive plan in 2018, up from 10 per cent in 2015) to generating acceptable economic rates of return versus absolute production growth (a.k.a. “growth for growth’s sake”). In addition, infrastructure (Permian pipelines to be at 90 per cent plus capacity by August), labour (2.5 per cent unemployment rate in Midland, Texas), and equipment shortages all are acting as further anchors to growth potential.
- The oil market in 2017 was undersupplied by 0.7 million bbl/d (as evidenced by inventory drawdowns at the fastest pace in history). When combined with demand growth of 1.8 million bbl/d, this means that supply would have to grow by 2.5 million bbl/d in 2018 to reach balance. With U.S. production constrained to about 1.2 million bbl/d, flat OPEC-Russia production, and non-OPEC/U.S. production to be up about 0.2 million bbl/d, it should remain obvious that the market will remain undersupplied. The last time OECD inventories reached our 2018 projected levels of sub 2.6 billion barrels, the price of oil (WTI) was above $70 per barrel (vs. $62.50 today).
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RAGING RIVER EXPLORATION (RRX.TO)
Last purchase on March 13, 2018 at $5.80.
Not unlike the rest of the energy sector, Raging River is trading at a fundamental disconnect to its inherent value. As a result, the company recently announced its intent to evaluate strategic alternatives, which is a move that we strongly applaud. Given extremely high inside ownership, the Raging River team recognizes that, to achieve a different result, they need to act differently rather than waiting for things externally to change.
With the stock trading at 4.0 times enterprise value/2018 debt-adjusted cash flow versus its proved developing producing (PDP) reserve life index of 3.6 times, the market is clearly not assigning its historical valuation premium, given a very high corporate netback (that is, margin per barrel), a strong balance sheet, an extremely well respected management team, and a potentially valuable asset in their East Duvernay Shale play. We see $8 to $11 a share in value, pending some semblance of a successful outcome with the process.
FTS INTERNATIONAL (FTSI.N)
Last purchase on March 10, 2018 at $19.72.
FTS is a newly public U.S. pressure pumper. With internal building capabilities, they have an inherently lower-cost structure relative to its peers and, as such, earn a significant EBITDA premium per active spread. U.S. pressure pumping demand could exceed 20 million hydraulic horsepower (HHP) in 2018, resulting in a still-undersupplied market with the potential for a further 10-per-cent price increase in 2018. Trading at 2.2 times 2019 EBITDA and a 36 per cent free cash flow yield, FTS is flying under the radar and being impacted by overly negative sentiment towards the service sector. We see 50 to 100 per cent upside in this name, given our view that WTI will trade to $70 per barrel in 2019 and that the demand for pressure pumping will continue to outstrip available supply.
WPX ENERGY (WPX.N)
Last purchase on Feb. 5, 2018 at $14.45.
WPX is a high-growth U.S. midcap oil company that operates in the U.S. Bakken and Permian basin. The stock is getting rerated in 2018 as they use excess free cash flow to pay down debt and get to their targeted 1.5 times debt-to-EBITDA level. With the potential to grow production by over 20 per cent within cash flow, we see 50 per cent upside in the name, as they’re trading at a 2019 enterprise value-to-EBITDA multiple of 5.5 times relative to a historical multiple of over 8 times. Furthermore, WPX possesses midstream assets that they’re likely to monetize for which they receive zero recognition for and yet, could be worth $3 to $4 per share.
PAST PICKS: MAY 23, 2017
TRICAN WELL SERVICE (TCW.TO)
- Then: $4.42
- Now: $3.23
- Return: -26.92%
- Total return: -26.92%
PROPETRO HOLDING (PUMP.N)
- Then: $13.70
- Now: $17.07
- Return: 24.59%
- Total return: 24.59%
U.S. SILICA HOLDINGS (SLCA.N)
- Then: $39.03
- Now: $26.20
- Return: -32.87%
- Total return: -32.33%
Total return average: -11.55%