Energy revival "certainly not over"

TDAM's Michael O'Brien expects cash-flow growth to fuel dividend increases and share buybacks.

Sonita Horvitch 28 May, 2014 | 6:00PM
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 Michael O'Brien, managing director at TD Asset Management Inc., says that although the stocks of Canadian energy producers have sprinted ahead in the year to date, many still have lots of room to run.

"This story is certainly not over; we could be at the beginning of the next leg of the upswing," says O'Brien, who manages Canadian large-cap portfolios using a GARP style, or growth at a reasonable price.

"Investor sentiment toward the oil patch this year is the polar opposite of what it was last year," he says, "when investors were rewarding the quick and dramatic growth in U.S. shale-oil production and souring toward the Canadian oil patch with the focus on its challenges with infrastructure bottlenecks."

O'Brien notes that after an initial spurt, production at the U.S. shale-oil projects tends to level off. "By contrast, the Canadian oil-sands offer long-life reserves and there is now a growing recognition that the world will need Canadian oil, after all."

He notes that many major Canadian energy producers have excellent growth in free cash flow. "This augurs well for increasing dividends and share buybacks."

Of late, O'Brien reports that he has been "whittling down" his exposure to the more traditional dividend-paying stocks or "bond proxies" -- such as telecommunication services, utilities and pipelines. These stocks have done well since the beginning of the year due to "the unexpected pullback in interest rates," he says.

O'Brien considers that the longer-term trend to rising interest rates is likely to resume. This will create a headwind for those companies that are unable to grow their dividends, he says.

With the proceeds of his "bond-proxy" sales, O'Brien has been increasing his weightings in non-bank financial stocks -- select insurers and asset managers. "These stocks weakened in the wake of the softening in interest rates."

Michael O'Brien

O'Brien has also added to his holdings in the more economically sensitive areas of the market such as well-placed U.S. industrials, including a railway stock, U.S. technology stocks and a Canadian auto-parts manufacturer.

At TDAM, O'Brien, who is head of the core Canadian equity team, is responsible for some $6.5 billion in assets for a large number of institutional and high-net-worth mandates at the firm. His mutual-fund mandates include TD Canadian Equity  TD Canadian Blue Chip Equity   and TD Balanced Income.

TD Canadian Blue Chip Equity is benchmarked against the S&P/TSX 60 index. At the end of April, the fund, with 45 names, had overweight positions in financials at 39.6% (36.5% in the index) and energy at 30.7% (25.8%).

Energy producers, at 24% of the portfolio, represented the bulk of the fund's weighting in this sector. Another 6.7% was in pipelines. The fund's third largest sector weighting was industrials at 7.2%, a market-weight position. Foreign content was 9.1% at the end of April, approaching the 10% maximum allowed under the fund's mandate.

O'Brien reports that the portfolio already has a "healthy exposure" to bank stocks and that he has added to non-bank financials including the insurer and asset manager Manulife Financial Corp. MFC. "The stock had a huge run in 2012 and 2013, and has been re-rated by the market, which is now focused on core earnings growth." Like other insurers, Manulife is perceived to benefit from a rising-interest-rate environment, he says.

Turning to energy, four producers that feature in TD Canadian Blue Chip Equity's top-10 holdings are Suncor Energy Inc. SU, Cenovus Energy Inc. CVE, Canadian Natural Resources Ltd. CNQ and Crescent Point Energy Corp. CPG.

Suncor is a fully integrated energy company with operations that include oil-sands development and upgrading, conventional and offshore oil and gas production, petroleum refining and retail outlets (downstream assets). "Its integration enables it to capture the value of a barrel of oil along the production chain," says O'Brien.

Canadian Natural Resources Ltd. Cenovus Energy Inc. Crescent Point Energy Corp. Suncor Energy Inc.
May. 26 close $44.51 $31.82 $44.57 $42.28
52-week high/low $45.60-$28.44 $33.11-$28.25 $44.99-$35.25 $43.47-$29.85
Market cap $48.0 billion $23.8 billion $17.7 billion $65.1 billion
Total % return 1Y* 45.3 6.9 23.1 34.9
Total % return 3Y* 3.5 -0.9 4.8 2.4
Total % return 5Y* 8.3 n/a 13.6 4.1
*As of May 26, 2014
Source: Morningstar

Canadian Natural Resources, by contrast, he says, "is a pure exploration and production company." Some 70% of CNQ's production is oil and 30% natural gas, says O'Brien. "I think that the long-term fundamentals for oil are superior to those for natural gas, which got a strong boost from the extremely cold North American winter." But, says O'Brien, CNQ has strategically been acquiring natural-gas assets, which were so out of favour and therefore reasonably priced.

O'Brien says that looking out a decade, both Suncor and CNQ have "strong free-cash-flow growth profiles, with Suncor ahead on this trajectory." This will allow for share buybacks and dividend increases, he says.

Cenovus has both upstream and downstream assets, says O'Brien. Key is its oil-sands operations, which include its 50% stake in two producing steam-assisted gravity drainage (SAGD) projects -- Foster Creek and Christina Lake.

"The company has stubbed its toe on Foster Creek, its largest oil-sands project." Foster Creek's production cut and higher costs last year disappointed the market, says O'Brien, with the height of the disappointment last fall. "The result was a contraction in the premium multiple on the stock, though it still trades at a slight premium to the group."

There is some uncertainty surrounding Foster Creek, says O'Brien. But most of Cenovus's portfolio, including Christina Lake, which has seen strong production increases, is on track. Also, the company pays a high dividend, which it has been increasing over the past three years, he says, and its stated strategy is to focus on dividend growth.

Crescent Point Energy is a "foil to the other three in that it is a classic shale-oil producer in the Canadian Bakken formation in Saskatchewan." The result, he says, is that it has to run harder than, say, oil-sands producers to keep its production growing. A former oil and gas royalty trust, Crescent Point has maintained its distribution/dividend and the stock's dividend yield is more than 6%, says O'Brien.

In keeping with his strategy to reduce his holdings in "bond-proxies", O'Brien sold his holding in Fortis Inc. FTS, a gas and electric utility. "It was a modest holding." He also pared back his holding in major Canadian pipeline company, Enbridge Inc. ENB, although the stock was still among the fund's top-10 holdings at the end of April.

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Sonita Horvitch

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