Canada has staked its future on the oil sands. In November, Report on Business magazine together with Thomson Reuters examine what that means both at home and abroad. Read more from the issue at tgam.ca/oil.
The oil sands are making investors nervous. Producers have shelved or delayed several major projects recently due to now-familiar worries: rising costs, weakening oil prices and opposition to new pipelines. Uncertainty often creates opportunity, of course. We surveyed 11 of the savviest money-makers and analysts in the oil patch for some advice. Four talked about how their investing styles guide their decisions. None of the 11 is gung-ho on the oil sands at the moment. But if you stick to a sound strategy and don't get rattled or excited by headlines, history and logic tell you that you should profit.
Rafi Tahmazian
Senior portfolio manager, Canoe Financial
Do you like the investment potential of Canada’s oil sands?
Not now. It all ended for us in December, 2012, when Ottawa approved the sale of Nexen to China’s state-owned CNOOC, yet made it difficult for foreigners to do more of these transactions. A lot of companies with oil sands leases need access to incremental capital, but the Canadian market is too small to handle that kind of financing. With that call, Ottawa severed ties to potential capital. Proposed pipelines like Keystone, Northern Gateway and Energy East could be catalysts for the sector, but they all have mountains to climb for approval.
– Shirley Won
Jennifer Stevenson
Vice-president and portfolio manager (energy), 1832 Asset Management LP; portfolio manager, Dynamic Funds
How does the energy sector compare with other industries?
It is certainly more cyclical, but ties into fundamental global tailwinds that are driven by macro items like increasing population, living standards, and GDP per capita. All of that global growth requires energy. The only source of real growth in global energy production is coming out of North America.
How much of a concern are worries about oil supply and demand?
I think the risk on oil is to the upside. Other producing regions, notably West Africa and the Middle East, have constraint issues caused by what’s going on geopolitically. The underlying growth from North American energy companies has not abated, but stock prices have come down with this pullback. So I think, as an entry point, it’s beautiful.
What are your top picks in the oil sands?
Two we like are Canadian Natural Resources and Suncor Energy, because both those companies have very long-term assets, very good cost control, increasing free cash flow and increasing dividends.
What is the one stock that investors should watch?
PrairieSky Royalty is interesting. As long as you think that there’s going to be oil-and-gas drilling in Western Canada, it’s a good long-term asset.
– John Tilak
Les Stelmach
Portfolio manager, Franklin Bissett Investment Management
Size matters: Stelmach likes yield along with growth prospects. “If you’re small, everything has to work according to plan,” he says about oil sands producers. “The rewards are certainly higher for getting a project up and running, but the risks are magnified.” Pitfalls could include unforeseen complications with a bitumen reservoir or trouble in raising capital. Either could cripple a small player. “But if Cenovus does another project, you know they’re not risking the company. They’re well capitalized.”
Building steam: Stelmach prefers steam-driven projects, since the environmental liabilities associated with open-pit mining are much higher.
At your service: Some of the best returns in the oil sands are generated by companies providing services and supplies – engineering and design, hauling waste, housing and feeding armies of workers, and so on. Though many providers are privately held or owned by multinationals, Stelmach says there are a few opportunities. His pick: Horizon North Logistics Inc., which provides work camps, catering and access roads in remote regions. “The stock’s been beaten up on a couple of weak quarters. With a business like that, there’s a certain amount of volatility there,” he says. “But the business looks good, the balance sheet’s in pretty good shape and it’s got a decent dividend yield.”
Prove it: On the production side, he favours the largest producers: Cenovus, Suncor and Canadian Natural Resources. “Most Canadian equity managers own those companies, just because they’re such a big part of the energy market capitalization. But those three in particular are proven operators.”
Favourite metrics: Steam-to-oil ratio for SAGD producers, and the total volume of bitumen in place for the miners – a measure of the amount of bitumen within the total amount of ground you would have to dig up and move. “Both relate to reservoir quality,” says Stelmach.
– Jeffrey Jones
David B. Krieger
Managing director (energy), Warburg Pincus
What is the top trend in the Canadian oil patch?
The wonderful growth and good returns from the application of horizontal, multistage fracking technology to unlock oil and gas reservoirs that weren’t economically viable before.
What makes a company an attractive investment?
Warburg Pincus has more than five energy investments in Canada, including Canbriam Energy Inc. and Osum Oil Sands Corp. We look for people who have a track record and a geologic and business thesis around how they’re going to grow their company.
Do you have an example?
Our first investment in Canada, back in 2004, was MEG Energy. MEG is now publicly listed, and we’re still its largest shareholder. In the early 2000s, oil traded as low as $18 to $20 a barrel. But we found a very talented executive in Bill McCaffrey, who had been a successful developer of oil sands projects. The combination of a great management team, a great asset and great technology that had just been proven commercially made it a great time for us to invest.
Where can investors find the best value in energy?
Whether it’s in the upstream side, the services side or the midstream side, you can find growth potential at good rates of return all over. We’re evaluating opportunities in all three areas in Canada.
– John Tilak
Jeff van Steenbergen
Co-founder, Kern Partners Ltd.
What do you look for in energy investments?
We focus on early-stage plays in exploration and development, infrastructure, services and related technology. The investments are mainly in Canada, Europe and the United States. We also have a program in which our limited partner investors can co-invest alongside our energy funds. When considering new businesses, we look for entrepreneurial leaders with unique strategies. We have invested in firms such as Steelhead LNG, Beaumont Energy, Altex Energy and Black Swan Energy.
How big is your stake in the oil sands?
It’s relatively small. We have made just two investments: MEG Energy, which went public in 2010, and an interest in Osum Oil Sands. Osum expanded this year with a $325-million purchase of Royal Dutch Shell’s Orion property in Northern Alberta.
Where do you see opportunities now?
We are interested in Western Canada’s liquids-rich natural gas plays in areas such as the Montney and Duvernay, as well as oil development plays like the Bakken in the U.S. There is increasing global recognition of Canada’s potential in non-conventional resources.
– Shirley Won
Martin Pelletier
Founder and portfolio manager, TriVest Wealth Counsel Ltd.
Pitfalls galore: “You’ve got commodity risk, infrastructure risk, capital risk, completion risk, environmental risk, and timing and cost overrun risk,” says Pelletier. Any one, or a combination of the above, can sink a project.
It’s the price of oil, stupid: “Just like the way long-term bonds react to the expectation of a rise or fall in interest rates, oil sands companies are highly sensitive to oil prices, because your capital is in there for a long time,” says Pelletier. Oil sands projects have to compete for capital with other energy assets – shale oil plays, for example, have similar development costs, but can start generating cash much quicker.
The upside: So, why invest in the oil sands at all? The big benefit is the ability to put money into assets that, in some cases, can produce steadily for decades, especially if you believe world oil prices will strengthen over time, Pelletier says. The prudent course, he adds, is to follow the capital to the projects that are most likely to get built and operate reliably. And those are most often run by the largest and most experienced players.
Good bets: His top picks include MEG Energy Corp., known for its steam-driven Christina Lake project. “I like the quality of their assets, and I like the management team. It’s a rock-solid company,” he says. MEG has separated itself from other small players that have struggled to get projects to the startup phase or to produce at planned rates. Cenovus, with its Foster Creek venture – one of the industry’s first steam-driven projects – is another favourite. Pelletier says both are off their highs, so they offer value.
Favourite metrics: Operating costs per barrel (a measure of efficiency and resilience to volatile oil prices) and asset values of specific oil sands projects, which are important because the oil sands are a long-term play on oil pricing.
– Jeffrey Jones
Lauchlan Currie
President, ARC Financial Corp.
What are your most important investment criteria?
We invest in private, Western Canadian energy and production companies, as well as oil-field service firms. They are usually startups where we are the lead investor. Key is a high-calibre management team. We want strong leadership, and a fully integrated team with the technical and commercial skills to build a company. Our portfolio includes names like Huron Resources, Tangle Creek Energy and STEP Energy Services.
How big is your stake in the oil sands?
It represents less than 5 per cent of our assets, and we probably won’t be investing there in the future. It has nothing to do with fundamentals. Oil sands projects require billions of dollars, and those deals are too big for us. We were a founding shareholder in North American Oil Sands, run by Pat Carlson, and it was sold in 2007 to Norway’s Statoil.
What have been your firm’s best investments?
We’ve had the best success with startups where we have had the maximum influence in shaping the team, capital structure and business plan.
Where do you see opportunities now?
We have had success from emerging resource plays in light oil and liquids-rich gas. I think we are in the early innings of the unconventional oil and gas business. Technology like multistage fracking is making big strides in getting well costs down. There is opportunity in oil services, too, but it’s a vast area so we try to identify underserved niches in that market.
– Shirley Won
Wade R. Felesky
Co-head, energy investment banking, GMP Securities
What is the key theme playing out in Calgary?
In the last couple of years, we’ve seen the rise of energy-focused private equity. When capital markets and commodity markets are challenged, it really sets the stage for private equity firms to attract large amounts of capital and displace public markets in many startups.
What makes a company an attractive M&A target?
In this type of environment, we look for growth companies that can continue to grow and capitalize on the resource, generate cash flow and preserve their balance sheet. On the income-plus-growth side, we look for companies that can maintain or grow their dividends without material changes to their adjusted payout ratios.
What do you think will happen next?
Capital market sentiment turned positive in 2014, and we think the M&A activity is going to continue to 2015. This is largely a function of volatile commodity and capital markets over the past couple of years, which forced companies to rationalize assets and reduce debt.
– John Tilak
John Stephenson
Founder, Stephenson & Co. Capital Management
Old World, New oil and gas: One of Stephenson’s favourite stocks is Vermilion Energy, a former trust with an international portfolio of properties spanning Canada, Australia, France, Ireland, Germany and the Netherlands. Vermilion’s European assets, in particular, are important given the region’s volatile geopolitics. “It should be obvious that Europe needs to diversify away from Russia as a primary supplier,” he says. Vermilion’s output is growing rapidly – estimates put 2015 production 25 per cent to 30 per cent higher than in 2013. The dividend, which currently yields about 4 per cent, has been rising at a modest pace.
Defensive play: With interests in natural gas and power production, AltaGas has built a diversified portfolio of energy infrastructure assets whose earnings are, in many cases, either regulated or governed by long-term contracts. The bond-like nature of AltaGas’s cash flows could make the stock vulnerable if interest rates rise, but the company has a track record of adding assets that enhance earnings. “Management is very conservative. They tend to underpromise and overdeliver,” Stephenson says. Another plus: AltaGas is poised to capitalize on liquefied natural gas exports, which will boost its bottom line and continue driving growth in its dividend. A favourite of income investors, AltaGas currently yields about 3.5 per cent, and “the dividend is rock solid.”
Oil sands retreat: Stephenson has been cutting his exposure to the oil sands. First, the assets are very long-dated and don’t offer a lot of growth, whereas conventional oil and gas companies can grow through exploration, acquisitions or accelerating existing production. Second, the break-even cost for oil sands producers is high – generally around $75 (U.S.) a barrel. With oil prices down sharply in the summer and early fall, any further weakness could raise questions about the viability of some projects.
Favourite metric: The ratio of enterprise value to earnings before interest, taxes, depreciation and amortization. It allows you to compare companies with different capital structures. Generally, the lower the EV/EBITDA, the cheaper the stock.
– John Heinzl
Kevin Lo
Managing director, Institutional Research, FirstEnergy Capital Corp.
What is the most undervalued sector within the energy industry?
The sector that I cover: energy services. Stock prices have decreased substantially, the outlook is pretty decent into next year, and dividends and free cash flow from these companies are quite high.
– John Tilak
Jim Hall
Chairman and chief investment officer, Mawer Investment Management
Oil to groceries: Hall prefers to describe his investing style as “growth at a reasonable price.” Either way, he likes a bargain. He’s after long-term returns – whether the company is an oil sands producer or a grocery store. “We look at all our investments as an opportunity to compound wealth over time, by investing in businesses that are compounding wealth themselves,” says Hall. “They do that by generating attractive rates of return on their capital and redeploying that capital wisely.”
The market rules: Oil sands producers offer unique benefits for investors, he says. They sell a product for which there is always a market, and demand keeps growing. Reserves can last for decades, even as production increases. But there are drawbacks: Producers have no control over oil prices, and there’s plenty of competition from other parts of the world. Meanwhile, projects are highly capital-intensive, which can keep a lid on returns.
Double-edged sword: Advances in technology can reduce costs or im-prove environmental performance, but they can also boost competing energy sources, says Hall. Just look at the rise of fracking, which has unlocked vast storehouses of shale gas in North America. “It made a whole bunch of reserves uneconomical.”
Big is better: Hall recommends the biggest players with the deepest pockets. Cenovus is at the top of his list. “It’s got a big resource, it’s got a well-defined process, it’s earning attractive returns, and there’s a long runway to grow and to keep producing,” Hall says. “The stock price is not reflecting all that, in our view.” Suncor is another strong performer that not only has a massive oil sands base, but has cut costs and increased investment returns in the past three years, says Hall.
Favourite metrics: Steam-to-oil ratio, operating cost per barrel, and up-time or reliability.
– Jeffrey Jones
Illustrations by Joel Kimmel