Resources roundtable: Cures for the energy malaise

Managers seek earnings growth, not just higher output

Sonita Horvitch 14 September, 2010 | 2:01AM
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Editor's note: The robust returns in natural resources in the recent past have come mostly from materials producers, while energy has languished. In the first of a three-part Morningstar manager roundtable, our panel of three portfolio managers discusses how they're playing the energy sector now. Our panellists are Benoit Gervais, vice-president, investments, at Toronto-based Mackenzie Financial Corp., who co-manages a number of resource funds with Fred Sturm including Mackenzie Universal World Resource Class  Robert Lyon, senior vice-president and portfolio manager at Toronto-based AGF Investments Inc., who oversees all of AGF's resources funds including AGF Global Resources Class; and Norman MacDonald), vice-president at Invesco Trimark Ltd., who manages Trimark Resources. Leading the discussion was Morningstar columnist Sonita Horvitch, whose series continues on Wednesday and concludes on Friday.

Q: Benoit, can you discuss the performance of the two components of the resource industry -- energy and materials -- over one and five years?

Gervais: Canada's S&P/TSX Energy Index had a total return of 10%, and the S&P/TSX Materials Index had a total return of 35% over one year to recent close. We can contrast this performance with the relevant world indexes. Over one year to recent close, the Global 1200 Energy Index had a negative total return of 5% and Global Material 1200 Index had a total return of 7%, both in Canadian-dollar terms.

Lyon: On a one-year basis and on a year-to-date basis, Canadian resource stocks have outperformed the global resource universe.

Gervais: The reason for the S&P/TSX materials index's outperformance relative to the global materials index is that the Canadian materials index is full of gold stocks and gold stocks have performed very well.

Lyon: The S&P/TSX materials index also has a heavy weight in agricultural stocks. Canada's Potash Corp. of Saskatchewan POT and Agrium Inc. AGU have done well.

Benoit Gervais: The Canadian materials index is full of gold stocks, and gold stocks have performed very well.

Gervais: Looking at the five-year performance, the S&P/TSX Energy Index produced a total return of 3% and the S&P/TSX Materials Index had a total return of 141%. Again on the global front, there is a big gap in performance between energy and materials. The Global 1200 Energy Index had a five-year negative total return of 2% and the Global 1200 Material Index had a total return of 47%, both in Canadian-dollar terms. Locally or globally, energy has done nothing for five years. The performance came from the materials sector. Canadian materials stocks with the high gold weighting substantially outperformed the global index over the past five years.

Q: Why has the energy sector done so poorly relative to materials over the past five years?

MacDonald: Let's start with natural gas. There was a belief in 2005 that an US$8.50 to US$9 per MMBtu (million British thermal units) was sustainable.

Lyon: The fall of 2005 was the last big spike in the natural-gas price.

MacDonald: It peaked at that time at US$12 per MMBtu and it has recently been trading under US$4. A lot of the natural-gas companies are not prepared to deal with the lower commodity price.

Lyon: We are near a bottom in the natural-gas price. The question is how high does it go on the rebound? I do not think that you are going to see US$12 any time soon.

Gervais: There is a major change in this industry. The horizontal-drilling technology is shaving costs. Importantly, there is a lot more natural gas than there was before, at a price that was lower than before.

Lyon: We have yet to see a demand response to the lower natural-gas prices relative to oil prices. People need to believe that these lower natural-gas prices will persist. Once this happens, users will realize that say at US$5, natural gas is better than say a US$80 per barrel of oil. Oil recently traded at US$73.

Robert Lyon: I do not think that you are going to see natural gas at US$12 any time soon.

Also, the natural gas producers' overall cost structures have not yet fully reflected the lower costs of the new plays. It takes time for the overall cost structure, earnings, cash flows and capital markets to realign.

MacDonald: Investors will want to see earnings growth, not just production growth.

Lyon: Exactly.

Q: Is this the time to buy natural-gas stocks, are they so washed out?

MacDonald: If you have a two- to three-year time horizon, you can buy them selectively.

Lyon: I do not think that the whole group is washed out. So Norm is right about the need to be selective.

Gervais: My call is that the best play will be to own pipeline assets with volume growing and the energy-services companies doing the natural-gas fraccing. In the portfolio, we have half our energy holdings in these connecting companies and half in exploration and development companies. Two U.S. companies that are natural-gas producers that own pipeline utilities that we like are El Paso Corp. EP and Williams Cos. Inc. WMB. They are in the top 10 holdings of Mackenzie Universal Canadian Resource  . Energy-services examples in Canada that we like are Trican Well Service Ltd. TCW and Calfrac Well Services Ltd. CFW.

MacDonald: The low natural-gas price could curb well development, including fraccing short-term.

Lyon: Longer-term, the demand for these services will be there. Also, you have to be selective when it comes to Canadian pipeline companies, as Canadian gas is being backed out of the United States. So TransCanada Corp. TRP is running with lower volumes. Benoit is right though. There will be a lot of derivative play winners in this natural-gas evolution.

Gervais: In Canada, Fort Chicago Energy Partners LP FCE.UN and Pembina Pipeline Income Fund PIF.UN have done well.

Q: What about oil?

Gervais: It peaked at US$145 a barrel in 2008. In 2005, five years ago, the oil price was in the US$60s.

MacDonald: The incremental non-OPEC oil supply is coming from the oil sands and the Gulf of Mexico. These two areas need at least a US$60 per barrel to get a modest rate of return, maybe 5%. Oil, at US$73, is appropriately priced in today's environment of global GDP growth of 1%-2%.

Norman MacDonald: Oil, at US$73, is appropriately priced in today's environment of global GDP growth of 1%-2%.

Gervais: There has not been a price lever in oil over five years. Also, it is difficult for the major oil producers to grow production. Exxon Mobil Corp. XOM, for example, is growing production at 1%-2% and its cost inflation is offsetting that.

Lyon: It has been a stock-picking game in the energy sector over the past five years. Some stocks have done well. Oil producers, for example, with significant internal volume growth that compensated for a flat oil-price environment have done well.

MacDonald: An example is Petrominerales Ltd. PMG

Lyon: There are also gas stocks that have done well in a declining natural-gas-price environment.

Gervais: The Canadian oil sands have been a big win for a lot of investors. This is an area where we are likely to continue to see volume growth. But some, like Canadian Oil Sands Trust COS.UN, which has no volume growth per trust unit, have been a disappointment. The Bakken play in Canada has also provided growth.

Lyon: Crescent Point Energy Corp. CPG, with its dominant stake in the Bakken oil play, is an example of a stock that has done well.

Q: What about the environmental concerns about the Canadian oil sands?

MacDonald: Most of the companies have been able to grow their non-conventional production through SAGD technology, steam-assisted gravity drainage. It has a lighter environmental footprint. Cenovus Energy Inc. CVE, one of the top holdings in Trimark Resources, is an example. There are others too. The growth in oil production at Suncor Energy Inc. SU is also being driven by SAGD.

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Sonita Horvitch

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