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Resources roundtable: Part 2

Large-cap Canadian energy stocks cheap by historic standards

Sonita Horvitch 18 January, 2012 | 7:00PM
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In today's second installment of our Morningstar roundtable series on natural resources, the managers discuss the challenges facing the oil and gas industry amid slumping natural-gas prices and the high costs of oil-sands development.

Our panelists:

 Norman MacDonald, vice-president at Invesco Canada Ltd., who is responsible for Trimark Resources and Trimark Energy Class.

 Robert Lyon, senior-vice president and portfolio manager at AGF Investments Inc., whose responsibilities include AGF Canadian Resources ClassAGF Precious Metals and AGF Global Resources Class.

 Scott Vali, vice-president and portfolio manager at Signature Global Advisors, a division of CI Investments Inc. Vali is responsible for CI Signature Canadian Resource and CI Signature Global Energy Class.

Their discussion was moderated by Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Friday.


Q: Energy constitutes 27.07% of the S&P/TSX Composite Index. The Canadian energy sector was down sharply in 2011, with oil and gas exploration and production companies among the poorest performers.

Lyon: This is largely because of the weak natural-gas price.

Vali: The natural-gas market has been depressed over the past few years. The technological changes that have taken place in respect to the exploration and development of wells has led to an over-abundance of supply, at a time when the economy was slowing. The North American winter has not been helping from a demand perspective. Prices have continued to drop.

Lyon: Canadian energy producers have their production more heavily weighted to natural gas and this weakness has had a meaningful impact on some of them.

MacDonald: Yet a major Canadian energy company like Suncor Energy Inc SU, which is predominantly in the oil space and is an oil-sands producer, did not have a good year in 2011 either. This is because the cost inflation that we were talking about in the mining industry has also impacted energy producers. It is a big negative for oil-sands producers.

 
Norman MacDonald

Vali: The equity market is realizing that it is expensive to start new oil-sands projects. You are seeing a valuation multiple compression on these stocks. The market is also realizing that the ongoing maintenance cost associated with some of these legacy assets is becoming quite onerous.

Lyon: It was only a few years ago that these companies would have said that with US$80-a-barrel oil, they would have been printing money on their oil-sands projects. Now, they need US$80 a barrel oil just to generate a return of 10% or 15% on capital employed. This sets the longer-term floor on the oil price.

Q: What of the service companies?

Vali: Canadian energy services actually did relatively well in 2011. There is a structural change in that industry. What is depressing the natural-gas market is benefitting the energy-services companies, because the wells are now more service-intensive.

Q: Valuations in the energy sector?

Vali: I am a growth-at-a-reasonable-price manager. In energy services, we like some of the larger-cap U.S. companies. Here the valuations are very cheap by historic standards. An example is National-Oilwell Avarco, Inc. NOV, which is the main energy-services stock that I own in Signature Canadian Resource. NOV is conservatively managed and has been able to opportunistically acquire assets. It is a dominant player in its space.

Some of the large-cap Canadian energy companies, such as Suncor and Canadian Natural Resources Ltd. CNQ, are cheap by their historic standards. I own both. But relative to their peers in the United States, they still trade at a premium.

Lyon: I am also a GARP manager. Because of the new technologies and the types of plays that the energy companies are going after, there is a significantly reduced exploration risk in a lot of companies and a longer-visibility of drilling opportunities and growth.

 
Robert Lyon

An example is Tourmaline Oil Corp. TOU, a natural-gas-weighted company. It is a major and long-standing holding in AGF Canadian Resources Class. This stock looks expensive on near-term earnings and cash flow, but the longer-term predictability of cash-flow growth deserves a premium valuation. It is a low-cost producer and has large, low-cost existing assets to exploit for many years to come. It also has one of the best management teams in western Canada.

Scott: I own Tourmaline.

MacDonald: So do I.

Lyon: If I go back 10 years ago, only oil-sands producers provided production growth visibility beyond 18 or 24 months.

MacDonald: I am a value manager. Many traditional exploration and development companies are moving to a manufacturing type of model and can command a higher multiple.

Lyon: There is less boom and bust in energy production. This is a reason why the valuation premium on oil-sands companies over some traditional exploration and production companies has compressed.

Vali: Greater predictability of cash flow applies to both oil and natural-gas producers. There are greater alternatives for investors seeking visible production growth in the energy sector.

You are seeing this in the United States as well. Companies like Devon Energy Inc. DVN, which is weighted towards natural gas, offer this production-growth visibility.

Q: Further points on valuation?

Vali: Many energy companies own their own mid-stream assets and are not getting credit for that. Investors are not paying for these assets, for example, in the case of Tourmaline.

MacDonald: Control of mid-stream assets gives the exploration and development companies a lower operating cost. Good quality management teams want to control their facilities.

Lyon: It is a competitive advantage.

Vali: Canadian Natural Resources is a great example. It is buying natural-gas assets, even though it has an unfavourable view on the commodity price. Because it owns the mid-stream assets, it is able to acquire the gas fields and move the gas through its own infrastructure at a much lower operating cost than the fields' previous owners. It becomes accretive to the company, even in a low natural-gas price environment. CNQ is the largest holding in Signature Canadian Resource.

Lyon: It is in my top 10 in AGF Canadian Resources Class

 
Scott Vali

MacDonald: It is in my top 15 in Trimark Resources.

Lyon: CNQ has about 70% of its production in oil. With its strong balance sheet, it is buying natural-gas assets near the bottom of the market. In the last few months, there have been a record number of gas assets for sale in Calgary, at fire sale prices. CNQ tends to zig when the other companies zag.

Vali: It has excellent management.

Lyon: Although the price of natural gas has fallen, so have costs in a lot of these resource plays.

Vali: Technology has altered the cost curve in North American natural-gas plays.

MacDonald: Shale-gas plays such as the Marcellus in Pennsylvania and the Montney in northeastern B.C. can do well in a low natural-gas price environment.

Lyon: The economics are being driven by the price of liquids-rich gas. A well that by volume is a gas well might produce say 80% gas and 20% oil and liquids. The value of the 20% liquids associated with that well at US$100 per barrel oil is huge. Norman mentioned the Marcellus and the Montney. The liquids in the wells in these plays are driving their economics.

MacDonald: The liquids in the gas include propane, butane, ethane and naphtha. These components are stripped out of the gas stream and sold separately.

Lyon: The price of these liquids is being driven off the oil price. If oil fell to US$50 a barrel, a lot of these plays would be uneconomic.

Vali: If the oil price stays where it is, the gas supply will, therefore, be more robust than it would have historically, given the current gas price. The companies will continue to drill, and gas prices will stay more depressed for longer than they would have historically.

Canadian Natural
Resources Ltd.
Tourmaline Oil
Corp.
Jan. 17 close $37.75 $22.44
52-week high/low $27.25-$50.50 $22.24-$35.96
Market cap $41.3 billion $3.6 billion
Total % return 1Y* -10.4% -3.9%
Total % return 3Y* 25.1% n/a
Total % return 5Y* 10.3% n/a
*As of Jan. 17, 2012. All figures $US
Source: Morningstar

Photos: paullawrencephotography.com

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Sonita Horvitch

Sonita Horvitch  

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