The Conundrum of the Energy Sector

Stock Market Outlook

In early October, we published our Quarterly Market Outlook and in our last Strategy Note, we pointed out the encouraging fact that the Economic Cycle Research Institute (ECRI) Weekly Leading Indicators had reversed to the upside over the preceding four weeks. That reversal has now carried through to the upside for a further two weeks. To recap: the WLI hit their fastest growth rate at +11.9% at the beginning of February this year but then declined steadily to a low of 0% seven weeks ago before recovering steadily to +3.2% in the latest reading.

As we have pointed out before, 90% of bear markets over the last 50 years have been associated with recessions. In almost all cases, U.S. recessions are associated with a reading for the WLI of -10%. Thus, the reversal in the ECRI to the upside is reassuring in that it suggests that there is little likelihood of a recession in the U.S. until the second half of 2018 at the earliest. With the normal cyclical lag for the TSX, we are hopeful that we could see some very

satisfactory gains over the next year in the TSX. As mentioned at the beginning of November, our conservative target for the TSX has been 16,000 (a level recently exceeded) but we suggested that this could well prove to be quite conservative if the 2017 year end oil price moves back to the $60 plus area a barrel. We still believe that global oil inventories are falling rapidly to normal levels and, assuming that Organization of the Petroleum Exporting Countries’

November meeting results in agreement to keep current production quotas through to the end of March, we would be much more confident that oil could move well past $60 a barrel over the next few months. Also, it appears that there is virtually no political risk premium built into the current price and recent arrests in Saudi Arabia of Princes and wealthy individuals suggest that some such premium could occur.

The recent rise on the oil price to the high $50’s has not been matched by the Canadian oil and gas stocks. This Strategy Note will review what has been happening in the Canadian oil and gas sector and the potential opportunity that exists although it would not be apparent from the year-to-date action of the stocks.

The Energy Sector

In those portfolios, where we are allowed to invest in commodity stocks, we have had a very difficult year – unlike 2016 which saw those portfolios all up well in excess of 20%. Last year’s outperformance was driven by the commodity sectors and the oil and gas sector in particular. One might have imagined that with the oil price (WTI) recently trading in the high $50’s for the first time since January, that the energy stocks would have had a very good year in terms of performance but the reverse has been true.

The same thing has been apparent in the U.S. although not to the same degree. However, the disparity between the price of crude and the price of oil equities has been significant. The sector in the U.S. industry, which is the most depressed – as in Canada – has been the service sector which by some calculations is being valued as though the oil price was just over $30. The integrated and Exploration and Production stocks in the S&P 500 are trading as if oil were a little higher in price but not by much.

In Canada, the performance of the oil and gas sector has been a lot worse outside of some of the major integrateds. The macro issues which have impacted the performance of the senior and intermediate producers have been pipeline access, uncertainty over carbon taxes and the price of Alberta Energy Company (AECO) gas. We will shortly discover whether Keystone XL will be approved but the Energy East project has been suspended as a result of the Federal Government imposing new conditions on the National Energy Board (NEB) midway through the approval process. Meantime, the BC Government has sworn to use any means at its disposal to prevent the Trans Mountain expansion from proceeding.

In addition, the cancellation of two BC liquefied natural gas (LNG) projects with Petronas’ $36 billion proposal being by far the most significant. The other cancelled proposal – Pacific Northwest – was the project of Nexen, owned by China’s CNOOC. These two cancellations together with the proposal by Alaska in the last week to be a 25% equity partner with the Chinese in a $43 billion LNG project has cast significant doubt in the minds of investors as to whether any BC LNG project might come to fruition. Significantly, Sinopec, which was a 15% partner in the cancelled Petronas project, is also a partner in the Alaskan proposal. Investor bearishness may well be overdone as the Shell-led LNG Canada project is still alive. However, the new BC Government will likely have to give ground on BC’s previous insistence on an LNG tax that LNG producers do not face in other countries.

Some of the above mentioned issues have most likely been behind Shell and Chevron’s decisions to exit the oil sands business in Canada. To fund the purchase of these assets required major equity issues by Cenovus and Canadian Natural Resources Ltd (CNQ). Since U.S. (and other foreign) investors were reluctant to buy these issues as a result of their own poorly performing energy sector and the macro issues referred to above, the funding came from domestic sources, who largely sold down their holdings of Canadian senior and intermediate producers rather than of the majors to provide the requisite funds. The net result of all of these factors has been steady erosion in valuations for the seniors and intermediates.

We are spending next week in Calgary visiting companies in our universe headquartered there. However, in the last two weeks, we were so puzzled by the continued decline in two of our holdings – namely Arc Resources Ltd. (ARX) and Peyto Exploration & Development (PEY) – that we conducted phone interviews with senior management of each respectively. To put their disappointing share performance into perspective, PEY is down 48% from December 31, 2016 while ARX has declined 31% over the same period. As a result of our phone interviews, we became aware of another depressant on the price of each. This was their statement that a group of hedge funds in the U.S. had come to the conclusion over the last number of months that Canadian natural gas stocks were a wonderful short. Because AECO prices had been weak, cash flow would suffer accordingly. These hedge funds had built a short position of close to 30 million shares in Peyto or 17% of the total number of shares outstanding – a bet of over half a billion dollars that the stock would continue to decline. In the short term, the size of the dollars being shorted can almost guarantee success.

However, as we hope to demonstrate later in this Note, a further decline is, in our opinion, not justified by the fundamentals. Unfortunately, as John Maynard Keynes famously said, “the market can remain irrational longer than you can remain solvent.” Arc Resources is regarded as another liquid natural gas stock and therefore a prime candidate to short although at current prices for oil and gas, the company’s revenue mix is roughly 50/50 from each commodity.

To illustrate how these pressures have hit the valuation of these two major holdings of ours, we would note that the price to cash flow multiple of each has averaged 8.3 times over the last 10 years in the case of Peyto and 8.5 times for Arc. At its current price of $17.26, PEY sells at P/CF multiple of 4.9 times (using Street consensus 2017 CFPS estimates) while ARC, at its current price of $15.95, sells at 8.3 times. On the consensus 2018 CFPS estimates, PEY sells at 4.3 times while ARC sells at 6.9 times. In 2018, PEY’s CFPS is estimated to grow by 13.5% and ARC’s 2018 CFPS is forecast by the Street to grow by 20.4%. In our view, a discount of 53% from the five-year average P/CF multiple in the case of PEY and 28% for ARC is not justified. However, one of the frustrations of a value manager such as we are, is that, in a momentum market such as we currently are in, stocks can be undervalued for a while and it is very hard to predict what the catalyst will be for these stocks to start reflecting value. Both reported production and cash flow for Q3 last week which was very much in line with our and the Street’s expectations and yet both stocks fell 10% in price. Satisfied with the short term results, we added to our holdings but obviously in retrospect, we wished we had waited before adding.

In sum, we have to admit to being frustrated at how our optimism on oil prices, which has been justified by recent action, has in no way been matched by the performance of the stocks we have owned (with the one exception of NuVista). But we conclude that now is not the time to throw in the towel. In these Notes, though the year, we have expressed the view that the oil price could get to $60 and beyond. In fact, global inventories are declining faster than we had anticipated and we believe surprises will be on the upside over the next few months. If anything, we are likely to be adding to our holdings with the emphasis being still on good balance sheet companies but with a greater percentage coming from oil rather than natural gas.

Portfolio Changes

Over the last two weeks, the only trades we made were those referred to above: namely adding to our Peyto Exploration & Development and Arc Resources Ltd. holdings. In our Advantage Equity portfolio, we funded these purchases by selling our Methanex position where we had very substantial profits while in our Dividend Growth portfolio, the additions to our Peyto and Arc holdings were funded through partial sale of Methanex together with a modest cutback in our Brookfield Renewable Energy position.

Nick Majendie

Senior Portfolio Manager

Director, Wealth Management