A month removed from oil's late-January lows, investors may be thinking the worst is over for the energy patch.
The evidence? In part, the robust performance of most of the members of the S&P/TSX capped energy index, a group of 55 exploration and production, services, and integrated companies. The stocks in the group fell, on average, 15 per cent from the end of 2014 to Jan. 28, the day West Texas Intermediate crude closed at $44.08 (U.S.). From that day forward, the average return is 16.4 per cent, with many of the companies returning 25 per cent or more.
Those leaders are not necessarily Canada's leading names: The eight biggest members of the index, by valuation, are among the 15 worst performers since oil's lows. The top stocks are smaller, more speculative, and in some cases deeply risky – raising the question of whether many junior and intermediate companies are getting ahead of themselves in what may a tough year for oil.
Certainly, a bull call on oil isn't the only reason for the gains. Trevor Reynolds, an analyst at Acumen Capital Finance Partners in Calgary, notes that some of the top-performing stocks, such as Lightstream Resources Ltd., Bellatrix Exploration Ltd. and Penn West Petroleum Ltd., were heavily shorted during oil's decline. "When people started to see any sort of bounce in oil, they definitely started to cover some of those shorts." (Short sellers borrow shares and sell them, hoping to profit by buying them back at a lower price later. When a shorted stock starts rising, the short sellers often move quickly to buy the shares and cover the short position.)
However, retail investors seem to be voting in favour of a rebound. According to data from Lipper, investors put a combined $8.4-million (Canadian) into the BMO Junior Gas Index and BMO Junior Oil Index exchange-traded funds in the week ended Feb. 18, raising their combined net assets by nearly 25 per cent. (The two ETFs invest in North American stocks, meaning investors get a mix of Canadian and U.S. names.)
That behaviour mirrors that of U.S. investors. Bloomberg reported this week that State Street Corp.'s small- to mid-cap SPDR S&P Oil & Gas Exploration ETF gained a record $696.6-million (U.S.) in January, even as flows into the broader category of energy ETFs fell from December's levels.
The reason the smaller names got hit hard in oil's decline, and have gained most in crude's modest rebound, is that exploration and production companies are more sensitive to the commodity's changes, as opposed to integrated energy companies. That means further gains in oil this year will have an outsized effect on those small-company shares, some of which are still down for 2014 despite recent gains.
Can an investor indiscriminately profit by picking the small names out of a hat, though? Not likely. The recent price gains have meant that even some of the favoured names by analysts are trading above their target prices.
At TD Securities, PrairieSky Royalty Ltd. and Whitecap Resources Inc. were two of the firm's 13 "best ideas" in the 2015 Junior & Intermediates Outlook published Feb. 2 just a few days after oil's lows. At $31.62 and $13.50, respectively, the two now trade above the firm's 12-month target prices of $30 (Canadian) and $13.
Whitecap has also exceeded BMO Nesbitt Burns's $13 target price. NuVista Energy, closing Friday at $8.19, is another name on the firm's "outperform" list that has topped its target price ($7.50).
The TD and BMO analyst squads still believe there are names with significant upside, even despite the recent gains. BMO has target prices for Raging River Exploration Inc. and ARC Resources Ltd. that are 25 per cent or more above current levels.
Analyst Jim Byrne says Raging River can deliver solid production growth this year despite oil-price weakness, maintaining a high growth rate that's accompanied by a solid balance sheet. Analyst Gordon Tate says similar things about ARC Resources: "ARC offers investors a balanced oil and gas profile combined with a solid balance sheet, plus meaningful growth and dividend payouts."
Among TD's "best ideas," Painted Pony Petroleum Ltd. is trading at the steepest discount to its target price, offering 42 per cent upside. The TD analysts estimate 2015 production growth for the company of 59 per cent, the highest among the junior and intermediate names TD covers. Painted Pony's capital budget demonstrates "how a consistent long-term development plan can buck the trend of reduced growth in a low commodity environment, especially when bolstered by technological improvement," the TD analysts said.
TD has a $9.50 target price for Bonavista Energy Corp., roughly a third above Friday's close of $7.16. The analysts believe its 50 per cent dividend cut and capital-budget reduction, announced in December, has moderated the dividend payout rate and reduced the company's need to issue future debt. The company has chosen balance sheet preservation over production growth, TD says approvingly.
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David Milstead