OT: tsx Oil picks and pans
Graham Scott
From the August 14-September 10, 2006 issue of Canadian Business Magazine
Who isn't aware of the boom in the energy sector? Since the early part of this decade, a series of geopolitical shocks, increasing demand from countries such as China and India, as well as new worries about the status of long-term reserves, have conspired to send the price of oil to record highs. But after that big run-up, production costs in the oilpatch are rising faster than oil itself — and that is stoking worries about inflation. Are Canadian energy companies still a good investment? Reporter-researcher Graham Scott polled several energy-fund managers for their takes.
General Outlook
Anil Tahiliani, McLean and Partners Wealth Management Ltd.: We're long-term bullish on the energy sector. If you didn't have any oil or gas in your portfolio, we'd say wait until there's a correction. In the last two weeks [July 21-Aug. 2] the gas market has really taken off, and all the gas plays have gone up significantly because of the extreme heat in the U.S. and Canada. But that might slow down come September, which would be an opportunity to buy. We see China and India driving the incremental global demand. We don't think China's going to be as big a factor as it was back in 2004 when we had a big jump in oil consumption. But based on its growing GDP, anywhere from 8% to 10%, annual consumption growth should increase by roughly 5% to 6% a year. If we're being conservative and take out the geopolitical risk, we say oil should be trading at US$55 to US$60.
Scott Carscallen, Howson Tattersall Investment Counsel: I've seen companies get caught up in acquisition mode when commodity prices are this high. They pay ridiculous multiples and ridiculous prices, and use debt to finance a lot of these acquisitions. So when the commodity price falls off, cash flows come under pressure and they've got all this debt on their books that they're forced to pay off. They start selling off some of the required production, and cash flow goes down as a result. It's a vicious cycle, but I see it happen all the time with each successive cycle. The guys that I look at have clean balance sheets, and I think they're able to weather the cyclical ups and downs of the underlying commodity price.
Integrated Majors/Senior Producers
Ari Levy, TD Asset Management: I like EnCana (TSX: ECA) for a lot of reasons. It has a gas strategy, but there is [also] a little-appreciated oilsands-expansion strategy, the real guts of which may be made public in the third quarter. Another name we like is Marathon (NYSE: MRO). It has several refineries with the potential to be linked to dedicated oilsands production, which is unique. It has also been bandied about as one of the names that EnCana would be wise to talk with. We also like Husky (TSX: HSE) and its ability to increase its upgrading capacity. Petro-Canada (TSX: PCA) has longer-term potential with its oilsands project. But it is also looking forward to very strong production growth in 2007 that people may be overlooking. Sure, recent quarters have been difficult — Terra Nova [gas field] has had some operational difficulties — but it will be coming back toward year-end. With Buzzard [gas field] coming on and White Rose being in full production, it is underappreciated.
Oilsands
David Whetham, Scotia Cassels: On a long-term basis, one of the big themes has to be the oilsands. There's so much oil that each of the companies there has a defined growth profile, which is hard to achieve at a traditional E&P [exploration and production] company where you're always dependent on drilling. In the oilsands, you know what's there. And the best company of the bunch is Suncor Energy Inc. (TSX: SU). It has good assets, it has been doing it a long time and it has got the most experience running and building projects. I think it's hard to beat.
The big weakness is that you have to make a vast investment to get the oil out of the sands, so there is more of a risk to these companies if the oil price declines significantly. There are also the input costs. One of the biggest is natural gas. You have to pump steam underground to loosen the oil before it flows to the surface, and to create the steam you have to use natural gas. I think it's a problem that the industry is going to have to address in the longer term.
But there are a couple of plays that are working on alternative technologies to avoid using gas. One of them is called OPTI Canada Inc. (TSX: OPC). They're building a plant in partnership with Nexen (TSX: NXY). Basically, what they do is they get the heavy oil out of the ground and then put it through a process where they take the best parts of the bitumen and make it into light oil. The rest they put through a gasifier and make a crude form of natural gas, which they then burn to create the steam to get more of the bitumen out so they can start the process all over again. The other approach is from Petrobank Energy and Resources Ltd. (TSX: PBG). They're using a process that they call THAI. They actually light a fire underground to loosen up the oil, which then flows out along a horizontal well. Again, you don't need natural gas.
AL: One company that plays well into this theme is North West Upgrading, a private company building an independent upgrader. It has just announced a transaction with Canadian Natural (TSX: CNQ) that will see CNQ dedicate some of its production while it ramps up its Horizon project.
Natural Gas
Glenn MacNeill, Sentry Select Capital: I thought the pessimism on gas earlier this year was getting overplayed. I still think we're going to get some very full storage levels between now and October, which will present more opportunities for buying gas-weighted companies and trusts. We continue to take positions when opportunities present themselves. Longer term, I'm very bullish on natural gas.
DW: Over the next several years, the gas market is going to look pretty attractive because we've drilled up the easy stuff. The traditional players are now only finding smaller fields that decline quicker. So we've seen overall production in North America decline over the last couple years. But every year demand grows because more houses heated by gas are being built. So what you have is a situation where production is going down and demand is going up. To take advantage of that you'd want to play the biggest player, which is EnCana (TSX: ECA). Its strategy has been to go after large fields of unconventional gas. So it has a pretty well-defined growth path.
AT: On the gas side, we like Duvernay Oil Corp. (TSX: DDV). Even though it says oil in the name, it's a gas play. And while the stock does trade at a premium relative to its peers, we think that's pricing in the management team, which has proven in the past it can perform. It also has a strong asset base.
Greg Bay, Cypress Capital Management: Given the weakness in natural gas prices, we've been buying natural gas stocks of well-managed, well-capitalized companies that have flexible capital programs that allow them to operate longer-term and use this time in the market to consolidate some of the weaker players. We're looking at companies such as Cyries Energy Inc. (TSX: CYS), Crew Energy Inc. (TSX: CR), ProEx Energy Ltd. (TSX: PXE), ProspEx Resources Ltd. (TSX: PSX) and, to a smaller extent, Zenas Energy Corp. (TSX: ZNS). They're not tiny companies by any stretch of the imagination: they're in the 8,000- to 12,000-barrel-a-day range. But they have had some pretty significant corrections through the early part of this year, when natural gas prices were weak.
Pipeline and Services
GM: We had a trip to the Mackenzie Valley pipeline project in June, and I thought it was pretty interesting. Again, whether it gets built or not continues to be a matter of costs, which continue to go through the roof. Native issues are a problem as well. But we're going to have to get that gas at some point in time. Because of the storage levels right now, it's not a pending problem, but the problem will come up fast down the road. Clearly, the pipeline companies will do well. TransCanada (TSX: TRP) for one. Imperial Oil Ltd. (TSX: IMO) is the lead on the project and it will do well. Mullen Group (TSX: MTL.UN) is one we own and like. Akita Drilling Ltd. (TSX: AKT) is another one that will do well. Flint Energy Services (TSX: FES) will benefit from the Mackenzie Valley project.
We've reduced our exposure in some of the gas-weighted service companies because we foresee a relatively soft gas market. So things such as Calfrac (TSX: CFW) and Trican (TSX: TCW), we've actually reduced. We've increased our exposure to CCS Income Trust (TSX: CCR.UN), which is more oil-oriented.
GB: There are a number of service companies we've owned for a long time. Trican Well Service is one. Some of them, we feel, are getting a little on the expensive side. But the odd tropical storm filtering through the Gulf will shake things up a little bit. You've got a tremendous amount of heat going through the U.S. right now. You've got to think those gas turbines are clipping around pretty quickly right now. So I think you'll see the storage levels come off pretty significantly over the next month or two, and that means you'll see drilling.
SC: Most in the service sector are getting rather pricey. One that I've liked for a while is NQL Energy Services Inc. (TSX: NQL). It's a company that manufactures motors for downhole drilling, along with some other manufacturing equipment. It has been in turnaround mode in the past few years and has shown quite a lot of good growth over the past year. I had heard that, with the fall-off in natural gas prices, the demand for rigs and equipment was starting to fall off, and that would create pressure for the regular common stock of oil service companies. This would be even worse for service companies that are income trusts because those are the guys who are obligated to meet cash flow distributions. I'm finding more opportunities with the producers, especially the ones who are exposed to natural gas.
Oil and Gas Trusts
AT: The biggest thing with the small income trusts is you've got to be careful. A lot of them are spinoffs of bigger companies, so you've got to look at the management team and you've got to look at the asset base. What sometimes happens is, in a spinoff the income trust is left with the mediocre assets while the exploration company gets the best assets. Management ends up going to the exploration company because it knows there's more upside on that. So you've got to find out with these small companies: where is the growth going to come from? That said, the smaller companies have the opportunity to grow faster than the larger companies.
SC: Growth in the income trust arena is getting tougher and tougher, and I'm seeing higher multiples being paid for acquisition targets and land being acquired at much higher multiples than has been traditional in the past. So things are getting very expensive out there right now.
Juniors
DW: On a longer-term basis, it's hard to pick a winner because companies in this sector are more dependent on drilling success, which makes them riskier. There are some very good management teams that have good track records. It depends. I could tell my mother to buy Suncor because you can buy it and put it away and it's probably not going to blow up. But even the best junior, I'm not sure. It's not just a buy-and-hold strategy.
SC: At this point in time, there are more investments in the oilpatch than I've ever seen — and I've been following it for quite a long period of time. I'll name three: Gentry Resources Ltd. (TSX: GNY), Geocan Energy Inc. (TSX: GCA) and Diamond Tree Energy Ltd. (TSX: DT). We're value investors, so it's been tough for us to find opportunities in the oilpatch. But what these three names have in common is they're all trading below their net-asset value, and that's what we use as our initial indicator. Usually there are reasons why stocks trade below their NAV, and I can say that, with Gentry and Diamond Tree, they have had a tough time getting production online. But that's just been the way it has been over the past year for most juniors. There has been a lot of wet weather in the oilpatch, and if you miss your production you get thrown in the penalty box, your stock price goes below net asset value. But these guys have been able to work through the problems. Wet weather clears up, you get the rigs onto the properties and you're able to bring production back online. Both of them have clean balance sheets, strong land acreage and a nice, balanced mix of low-to-medium properties with a few higher-risk, higher-impact properties. Neither is planning to blow their brains out on high-risk, expensive projects.
With Geocan, it's a slightly different story. It's below its net asset value. Traditionally, it had a bit of exposure to heavy oil, which is a lower-quality product that is more costly to refine, so, typically, companies exposed to heavy oil trade at a discount. Geocan, however, has evolved through acquisitions. It reduced its heavy-oil exposure — I'd say, from 80% down to less than 50% — and it's continuing to decrease. It deserves a higher multiple on its net asset value, but it'll take some time for the market to realize it's no longer strictly a heavy-oil play. As well, like Gentry and Diamond Tree, it has a nice mix of low- to medium-risk properties, with a few higher risk. It's not going to blow its brains out, and it has a reasonably clean balance sheet.
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