Natural resources equity roundtable: Part 1

 Scott Vali, vice-president and portfolio manager at Signature Global Asset Management, a division of CI Investments Inc. His discipline is growth at a reasonable price. Vali's responsibilities include CI Signature Global Resource, CI Signature Global Resource Corporate Class, CI Signature Global Energy Corporate Class and CI Signature Gold Corporate Class.

 Robert Lyon, senior vice-president and portfolio manager at AGF Investments Inc., also a growth-at-a-reasonable-price manager. His responsibilities include AGF Canadian Resources Class, AGF Precious Metals, AGF Global Resources Class and AGF Global Resources.

Q: Canadian and global energy stocks outperformed Canadian and global materials stocks, respectively, in 2013. The performance differential was particularly marked in Canada with materials stocks producing a huge negative total return, while Canadian energy stocks held their own. The performance differential between these two sectors was more modest in the global indexes.

Lyon: This reflects the fact that some 50% of the Canadian sector is made up of gold stocks, which were down sharply last year. Gold stocks represent a much smaller percentage of the global materials index.

Scott Vali and Robert Lyon

Q: Let's start our discussion with energy, which is the bigger weighting in your resource portfolios.

MacDonald: I had positive performance in U.S. energy stocks versus Canadian energy stocks last year. This highlighted the importance of U.S. unconventional oil-shale plays. There is, for example, Eagle Ford Shale, [a sedimentary rock formation underlying much of South Texas]. What is unconventional? It refers to the technology being used to access more of the oil in place than has been the case in the past. This technology consists of horizontal fraccing and directional drilling versus conventional vertical drilling. Furthermore, the commodities -- oil and natural gas -- behaved well in 2013. Natural gas was a star performer last year. You had both drilling acceleration and a cash-flow increase from these U.S. companies.

Lyon: Overall, U.S. energy stocks outperformed Canadian energy stocks last year, partly due to the oil-price differential between the United States and Canada, which punished Canadian producers. Canadian oil prices were significantly below both U.S. and global benchmarks.

	Index	Currency	1 Yr	3 Yr	5 Yr	10 Yr
	S&P/TSX Capped Energy TR	C$	13.3	-2.8	7.8	8.6
	S&P/TSX Capped Materials TR	C$	-29.1	-19.2	-0.7	4.7
	S&P Global 1200 Sec/Energy TR	US$	16.9	6.9	11.5	11.1
	S&P Global 1200 Sec/Materials TR	US$	3.5	-2.5	13.0	9.2
	S&P/TSX Composite TR	C$	13.0	3.4	11.9	8.0
	For periods ended Dec. 31 Source: Morningstar

Vali: In North America, the lack of sufficient infrastructure has become a challenge. Because of the growth from the U.S. shale plays, we have saturated the continent with crude oil. The further the wells are away from the major refining systems, the bigger the price discount on the product. The largest refining system is in the Gulf of Mexico. Canadian producers that cannot get their product down there efficiently, because of a lack of pipelines and/or a reliance on rail, are seeing a bigger discount to the global benchmarks than are some of the U.S. energy companies.

Q: Will these infrastructure bottlenecks and the resultant price discounts persist?

Vali: To some extent they will. There is not a lot of excess capacity to move crude or refine crude in North America.

MacDonald: Refining companies and mid-stream companies in the United States have considerable opportunities to expand. But this takes time.

Lyon: The pipeline companies are going to get there eventually. But the increase in production in the United States, in particular, has been so dramatic and so rapid, that it has caused this problem. Rail has been a short-term solution for transporting crude, but there are safety and cost issues. Even rail has had a hard time catching up to how quickly production has grown.

Robert Lyon

On the pipelines, the challenges facing Keystone XL and Northern Gateway and a number of other initiatives show that the pipeline-approval process has become more difficult, at the exact time when we need the pipelines the most. This all unfortunately means lower prices for Canadian producers, also for the Bakken shale, [which straddles the U.S./Canada border] and for some of the other northern U.S. producers.

Q: What is the outlook for oil and gas prices?

Vali: Focusing on West Texas Intermediate (WTI), we think that crude will trade in the US$80 to US$95 per barrel range longer-term. Below US$80 some of the production growth would be challenged. This translates into a global price of US$90 to US$110 per barrel. What of Canadian prices? There are some pipeline projects that are coming on stream in the back half of 2014 and this should help to reduce the price differential. The longer-term discount is likely to be US$5 to US$6 on WTI for an equivalent-grade crude.

On natural gas, if we get to a price of around US$4 to US$4.50 per thousand cubic feet, there is a lot of economic gas that can be developed and brought to market quickly.

Lyon: My view on the outlook for oil and gas prices is similar to Scott's.

MacDonald: I am a little more cautious on oil than Scott and Bob. This U.S. oil renaissance requires a price of oil at US$75 a barrel in the United States for the companies to earn a return on their capital. Oil in the United States, therefore, has a secure base at US$75 per barrel. I don't see a situation where WTI and Brent, the global price, can trade above US$100 per barrel in 2014.

Q: What helped to attract investor attention to U.S. unconventional shale plays in 2013? Scott, you have a significant weighting here.

Vali: Yes I do. In 2013, U.S. producers improved their understanding and their application of the technology. They could better quantify how much oil they would be able to capture. These estimates continued to expand. The market had not anticipated this early on.

MacDonald: I would caution about extrapolating the good performance of these U.S. companies in 2013 into 2014 and 2015. There needs to be a greater emphasis on stock picking.

Vali: Agreed. As the pace of these companies' understanding of the technologies advanced and production growth accelerated along with an improvement in costs in 2013, the equity market started to price this in quite aggressively. Some companies have more recently indicated that the market's expectations that they would show even bigger growth in 2014 would not be met. This disappointed investors. The stocks have pulled back since last October and November. There are opportunities. There are still companies learning what kind of resources they have available to them and, as they prove that out, investors will reward them.

Norman MacDonald and Scott Vali

Lyon: We started from a base of low expectations for these U.S. shale plays. The equity market now has higher production-growth expectations built into most companies' share prices. But, some parts of the United States are running into the same infrastructure constraints that the Canadians ran into. The Marcellus Shale play in the northeastern United States, for example, could grow unconstrained for several years. Last year it ran into takeaway capacity constraints. This could happen to some of the other basins in the United States and hamper the production growth of the companies involved in them.

Q: What stocks are the poster children for these unconventional plays?

Vali: When a play is discovered, everyone with acreage in the play benefits. The equity market initially bids them all higher. The market then starts to focus on those companies that have the best acreage within those plays. If you look, for example, at the North Dakota Bakken, it would be companies like Continental Resources Inc. CLR and EOG Resources Inc. EOG. I own both companies.

MacDonald: I have Whiting Petroleum Corp. WLL.

Lyon: I also own it.

MacDonald: Whiting trades at a discount to its net asset value. It also has a holding in the DJ Basin [north-east Colorado] and the potential from this is not factored into the stock.

Lyon: It's important to emphasize that a fair bit of the equity market's differentiation between the haves and the have-nots in these U.S. basins already happened in 2013.

Photos: paullawrencephotography.com