Mixed emotions from energy fund managers

“We saw a broad-based market correction from April to October, which impacted all cyclical types of names,” says Garey Aitken, chief investment officer with Calgary-based Bissett Investment Management Ltd. and lead portfolio manager of Bissett Energy Corporate Class Fund. “And weak natural gas prices had a big impact on many names. It was a ‘tale of two cities’ from a commodities price point of view. We continue to be mired in a very challenging environment for natural gas prices.”

Although geopolitical tensions in the Middle East have pushed up crude oil prices, excess supply and a mild winter have resulted in natural gas prices of about $2.50 per million cubic feet (mcf), vs about $4.50 per mcf a year ago.

Aitken says he is not overly bullish or pessimistic on the sector. “It’s a sector in which there will be winners and losers,” says Aitken, a bottom-up stock-picker who shares fund-management duties with Les Stelmach, vice president of Bissett. “There is no getting away from the fact the sector is cyclical in nature and geared to global economic growth,” Aitkin continues. “But I don’t think the sector is vulnerable, and valuations are not too stretched. We’ve come a long way from the lows made in March 2009. And we are not at peak levels, with the exception of the least loved names, which are most leveraged to natural gas.”

In a portfolio with about 45 positions, about 38% of the Bissett fund’s assets under management are in exploration and production companies, 31% in equipment services, 14% in oil and gas drilling, 4.7% in integrated energy companies and oil and gas producers, with smaller holdings in areas such as pipelines and 6.5% in cash.

One favourite name is Savanna Energy Services Corp., which provides contract drilling and services rigs in Canada, the U.S. and Australia. Says Aitkin: “[Savanna] is clearly a beneficiary of good pricing levels. Utilization rates for its equipment are robust. It’s a cyclical business, but we see secular growth.”

Although Aitken is reluctant to offer a target share price, he says the stock is worth twice as much as its current $7.60 share, or about four times enterprise value to earnings before interest, taxes and depreciation and amortization.

Another top holding is Canadian Natural Resources Ltd., a senior oil and gas producer with properties in Western Canada, the North Sea and West Africa. This firm’s stock has languished so far this year, largely because of temporary problems with its Horizon oilsands facility, which accounts for about 15% of its total production of 630,000 barrels of oil equivalent (BOE) a day. “But if we took the bigger picture,” says Aitken, “the company has terrific assets, and an excellent cost structure.”

Canadian Natural Resources’ stock is trading at about $37.60 a share, or 5.5 times enterprise value to debt-adjusted cash flow. Aitken believes the stock is worth more than $50 a share.

Last year’s market was driven by fear of contagion from the European debt crisis, says Eric Nuttall, a portfolio manager with Toronto-based Sprott Asset Management LP who oversees Sprott Energy Fund. “It was a manic market, not based on identifying companies with strong fundamentals. We had manic inter-day swings of 3%-4%. Volatility was extremely high and forced investors to the sidelines.”

Sentiment has begun to improve and worries have abated in Europe, as Greece has received another financial bailout. “We also have consistent economic statistics coming out of the U.S. that point to stabilization, if not an improvement,” says Nuttall. “The doomsday trade is off the table. While statistics in China point to a slowdown, it still has positive economic growth. It’s reflected in oil demand up at least 3% year-over-year. With current oil prices, it’s an incredibly profitable business.”

Stock prices have also rebounded year-to-date, notes Nuttall, adding that firms such as Suncor Inc. are up by 25% after dropping by 21% last year: “Companies are merely playing catch-up this year to what the fundamentals had approved last year.”

But it’s uncertain whether the trend is sustainable, he adds: “I’m not contrarian by nature. But when it’s a one-way market, it makes me somewhat cautious. The fund is semi-defensively positioned only because, while I believe that a high oil price is sustainable, I would not be surprised if we had a ‘check-back’ in oil prices.”

Moreover, Nuttall remains very bearish on natural gas and argues that stocks are not reflecting the weak natural gas price: “There could be a significant sell-off in natural gas stocks.”

In a concentrated fund of about 30 names, about 80% of the Sprott fund’s AUM is in oil producers, with 10% each in natural gas producers and energy services. One top holding is TriOil Resources Ltd., a small-cap light oil producer that was under pressure last year because of mixed success within the Cardium play in Alberta. “But [TriOil has] drilled several highly successful wells,” says Nuttall, “for which it had multiple increases in productivity.”

TriOil stock is trading at about $3.60 a share, or about four times 2012 cash flow. “When you look at the resource potential for the company,” Nuttall says, “the stock could be much higher.” Nuttall has a target of about $7 a share within 24 months, largely because daily production has the potential to rise to more than 5,000 BOE from 3,000 today.

Another favourite is Painted Pony Petroleum Ltd., which produces a 75/25 mix of natural gas and oil and is involved in British Columbia’s promising Montney natural gas play. “[Painted Pony] is the most strategic property in relation to Kitimat, which will open a liquefied natural gas facility in 2015,” says Nuttall. “Painted Pony continues to have a well-delineated land parcel that could be worth $18-$20 a share. Whether it happens in 2012 or 2013, I don’t know.”

Painted Pony shares are trading at about $8.76 apiece.

Although energy stocks have been rebounding, Rafi Tahmazian, a partner with Calgary-based Canoe Financial LP, and portfolio manager of EnerVest Natural Resources Fund, is skeptical about their prospects.

“I remain fairly cautious, and my investments tend to look more like larger, ‘flight to quality’-type names,” says Tahmazian, adding that 13% of the EnerVest fund’s AUM is in cash.

There are several reasons for his caution. One is the recent strong equities market for new issues. “The producers and service companies are not stupid,” he says. “They’re raising equities because they think there is an opportunity to raise money and take some pressure off the commodities price killing their revenue stream. There’s nothing too wrong with raising money. But, historically, when equities market windows open, these companies take money that would normally be used to buy existing stock.”

Tahmazian anticipates a repeat of last year, when a strong equities market in March was followed by a severe slump.

Tahmazian’s second concern involves natural gas production: “With gas at $2.50 [per mcf], there isn’t a lot of the opportunity to grow. And with gas so low, it’s killing the cash flow of companies [involved mainly in natural gas production].”

Finally, he believes the service sector could be vulnerable, as it may encounter less demand for new equipment this year: “We’re in an environment [in which] gas prices are down and capital programs will probably be curbed. That’s my fear. If the producers are reducing their capital programs, that spells a potential problem for the service sector.”

In a defensive stance, Tahmazian is running a fund with about 25 names that tend to be mid- to large-cap companies that could weather the turmoil or whose longer-term prospects look fairly secure.

One favourite holding is Mullen Group Ltd., which is engaged in heavy hauling, with about half of its revenue coming from the oilsands sector. “Being tied to the oilsands is critical,” says Tahmazian, adding that the stock has a 4.6% dividend yield. “[Mullen has] better visibility of earnings than most other service companies. What better way to sleep at night than to know your company has clients that know how they will spend their money for the next three years?”

Mullen’s shares are trading at about $21.60 a share. Tahmazian has no stated target.

Another favourite is Baytex Energy Corp., which produces about 53,000 BOE a day of heavy oil from its properties, mainly in Alberta and Saskatchewan. Says Tahmazian: “Management and [the firm’s] track record give me confidence.”

Baytex stock is trading at about $57.82 a share and yields 4.5%. Although Baytex stock trades at a premium multiple of 11.3 times enterprise value to debt-adjusted cash flow (vs 9.5 times for its peers), Tahmazian says, “This is a company that has a strong history and deserves to trade at a premium. You have to pay up for quality today.”

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Correction: The one-year, two-year and three-year returns for Enervest Natural Resources fund, as of Feb. 29, 2012, were -14.8%, 12.6% and 32.8%, respectively. Incorrect information, supplied by the fund sponsor, appeared in Investment Executive’s April 2012 issue.

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