Crude oil prices have rebounded significantly in the past year, moving back up to about US$48 a barrel, after members of OPEC agreed to production cutbacks in November. Portfolio managers of energy funds are bullish about prospects for the sector, noting that supply and demand are in far better balance.
“The rally is sustainable, although the trajectory of the rally will be less steep than before,” says Jennifer Stevenson, vice president at 1832 Asset Management LP in Calgary and portfolio co-manager of Dynamic Strategic Energy Class Fund. “The main driver is the OPEC deal. Even though we were already drawing down inventories, because demand continued to march up and supply was rolling over, having OPEC and some non-OPEC members agree to a production cut expedites that whole process.”
In the past couple of years, Stevenson notes, daily production exceeded daily demand, which resulted in growing inventories. Now, demand has kept growing while supply has dropped.
“As we go forward with the OPEC cut, daily demand is higher than daily supply. So, we will draw down global inventories, of which the U.S. accounts for the largest portion. Drawing down excess inventories is very supportive for prices,” says Stevenson, who works with Oscar Belaiche, senior vice president at 1832 Asset Management.
The situation for the past two years was exacerbated by the strong U.S. dollar, which weakened demand for oil, as well as speculative activity by non- producers who focused on selling the commodity short.
“The speculators got their heads handed to them, which was lovely to see,” says Stevenson, referring to the abrupt reversal of speculative positions in the second half of 2016. “People still are investing in crude, but a lot more are on the long side of the equation.”
Stevenson believes that the crude price could move 10%-15% higher, reaching about US$60 by year-end: “Demand still is strong. We have OPEC cuts that are underway and production is still rolling over in many non-OPEC countries because of the lack of capital- in places such as Mexico and China. And the U.S. is beginning to drill more and will grow production. But that is not something that will happen overnight.”
Stevenson has been gradually investing the cash in the Dynamic fund; cash now accounts for 9% of the fund’s assets under management (AUM) vs 40% in February 2016. About 60% of AUM is held in oil producers, 10% is in natural gas, 10% is in service providers and 11% is in energy infrastructure. Geographically, the U.S. accounts for 44% of the portfolio, with Canada at 43% and Europe at 10%.
One top holding in the 36-name Dynamic fund is Anadarko Petroleum Corp., an exploration and production firm that produces about 800,000 barrels of oil equivalent (BOE) in places such as Colorado, Texas and the Gulf of Mexico. “The assets are very high-quality and management knows what it’s doing,” says Stevenson.
Anadarko stock is trading at US$68.65 ($87) a share, or at about 7.5 times free cash flow (compared with eight to nine times cash flow for its peers). Stevenson believes the stock could be worth about US$85 by yearend.
Opec’s role is a crucial part of the crude oil price rally, says Rafi Tahmazian, director and senior portfolio manager with Calgary-based Canoe Financial LP and portfolio manager of Canoe Energy Class Fund.
“But that decision [to cut production] only happened in November,” he says. “The energy rally actually began in January 2016. But if you got in Jan. 1, you were down by 23% by Jan. 17 – which, looking back, turned out to the right time. But participating aggressively [was difficult] because the wounds still were gaping from the disastrous 2015 energy market. So, you had to creep in.”
Between January and October 2016, Tahmazian says, the market returned to a normalized level as speculators began to exit their short positions. “The oil price was creeping back to a price based on fundamentals of supply and demand,” he says.
Last autumn, the combination of the election of Donald Trump as U.S. president and the OPEC decision greatly helped to sustain the rally, Tahmazian adds: “The first event was good. Only afterward did we realize that you had a more pro- business, pro-oil individual in power. The “Trump factor’ still creates a lot of unknowns for our sector, of course. But, generally speaking, [The effect] is directionally positive. Then, we had to wait for OPEC – and [OPEC] made the right decision. The combination of OPEC and non-OPEC countries agreeing to cut [production] was a very powerful message to our sector.”
Coming off a low bottom, energy funds have seen double-digit returns in the past year. And that raises questions about the future.
“Has this gone too far, too fast?” asks Tahmazian. “I tell people that for various reasons – primarily, the collapse of the Canadian dollar, lower energy service costs and new multi- fracking technology becoming more efficient, you get the same margins at US$50-US$70 that we used to get at US$100. It’s a new world with new factors that create good profitability in a lower price environment.”
Tahmazian argues that the energy sector has gone through the capitulation and debt- restructuring stages and is “into mergers and acquisition activity. All of this is part of the early stages of the energy rally. The next level of the cycle [is] when we see new [energy-related] equities markets.”
About 20% of the Canoe fund’s AUM is held in cash as Tahmazian assesses developments in the sector. He is a tactical investor who moves quickly in and out of sub-sectors depending on weather conditions. Warm weather this winter, for instance, made him abandon natural gas producers.
“We built up our oil producers after the OPEC meeting,” Tahmazian says. “And we’ve had a very aggressive position in the service industry since last spring.”
About 50% of the Canoe fund’s invested AUM is held in oil producers, 30% is in service providers, 5% is in natural gas and about 8% is in private equity holdings.
One top holding in the 24-name Canoe fund’s portfolio is Tamarack Valley Energy Ltd., which made a recent acquisition that raises production to about 22,000 BOE a day from 15,000 BOE, mainly in central Alberta. Tamarack Valley stock is trading at $3.30 a share, or six to 6.5 times 2017 cash flow.
“We expect 10% growth in 2017, which we think is extremely reasonable,” says Tahmazian.
There is no stated target.
Opec’s decision to cut production is the main reason for the rally in oil prices, agrees Les Stelmach, senior vice president at Calgary-based Franklin Bissett Investment Management, a unit of Franklin Templeton Investments Corp., and portfolio co-manager of Franklin Bissett Energy Corporate Class Fund.
“When the announcement was made that not only would OPEC cut, but it offered a fairly detailed schedule stating what member will cut what amount and within what time frame – that was the catalyst that got the market into ‘believer’ mode,” says Stelmach, who works with Garey Aitken, chief investment officer at Bissett.
Stelmach notes that the unexpected Trump election and strong equities markets only added to the momentum. “The equities themselves were in a recovery earlier than [crude oil]. But [the recovery] had been tepid. We hit rock bottom in February 2016, when crude fell below US$30. Then, we had factors such as falling production in the U.S. and elsewhere. It took the OPEC announcement to make the rally stick.”
As far as the sustainability of the rally is concerned, Stelmach says: “We have seen the worst of it in terms of the rollover in crude prices. I don’t think we will go back to those grim days when oil was below US$30 a barrel. In one sense, being now [about] US$50 does not sound like a huge improvement. But it is a massive, proportionate change in the prospects of oil businesses.”
Stelmach says that although companies had serious challenges maintaining profitability at US$40 a barrel, they can make money at US$50 – thanks, in part, to technological improvements in drilling: “We are seeing a better overall environment.”
He is reluctant to forecast the crude price, except that it will go higher. “It might be a gradual process,” says Stelmach, adding that OPEC production cuts and modest capital spending plans in North America will be stabilizing factors. “The market is telling you that prices should get up to the US$60 level. But, actually, the futures curve is pretty flat. There is not a lot of bullishness about long-term pricing. We’ll see how that plays out.
“Very few long-term projects are being commissioned,” he continues, “which suggests we could face a supply shortage some years out.”
About 10% of the Bissett fund’s AUM is in cash, which Stelmach says he intends to deploy: “We want to be fully invested. But we don’t like to be hasty about it.”
About 55% of the invested portion of AUM is held in exploration and production firms, 30% is in service providers and 15% is in infrastructure.
One top holding in the 55-name Bissett fund is Raging River Exploration Inc., which anticipates producing about 22,000 BOE a day this year, mainly in Saskatchewan. “[Raging River] has low capital costs, and is quite profitable,” says Stelmach. “And [its] balance sheet is pristine.”
Raging River stock is trading at about $9.45 a share, or less than eight times enterprise value to debt-adjusted cash flow. There is no stated target.
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