The Energy Report: Eric, in your Q411 market commentary for Sprott Energy Fund, you describe 2011 as a challenging year. What made the market so difficult for investors?
Eric Nuttall: There were several factors: First, the weather failed to cooperate in Canada, where we had a very extended breakup in southeast Saskatchewan. We had epic levels of rainfall. We also had raging forest fires in parts of Alberta. The weather led to a low level of activity for much of the first half of 2011, and many companies struggled to fulfill their capex programs and meet their production targets. Natural gas pricing was very weak, which is something that I expect for the remainder of 2012. Meanwhile, equity markets were very volatile. There were many different factors, all of which oil and gas companies had to contend with.
TER: You commented that despite the fact that, for the first time in history, the price of Brent crude oil averaged more than $100 per barrel (/bbl) during 2011, oil stocks languished. What was the issue here? Are markets fearful of negative global macroeconomic events?
EN: In a word, yes. European debt issues captivated the public's attention for much of 2011, specifically worries about Italy, Portugal, Spain and most obviously Greece. Today, those fears seem to have abated somewhat, but there's still a tremendous level of uncertainty. I think there's lingering psychological trauma from 2008 and 2009 that encourages people to approach the market from a fear-driven mode as opposed to a greed-driven mode, meaning the appetite for risk is very low. You can see that in mutual fund industry money flows, where the only funds that are really garnering large cash inflows are dividend- or yield-oriented funds. That indicates retail investors are still worried we'll have some unexpected event that will lead to a selloff similar to the one markets experienced in 2008 and 2009. Most people simply can't afford to endure another one of those.
TER: Let's shift our focus to oil price action. Oil is up about 3–5% over the past 12 months, but it's basically flat. Is this a period of consolidation? What does that mean for equities?
EN: It is a period of consolidation, and share prices today reflect that industry environment. Many stocks have descended well over 20% within the past two months. We've experienced a sharp selloff even though oil prices have remained very strong, and it feels like the market is oversold despite strong fundamentals. Although we had a poor U.S. employment number for March, I think people missed out on the operative word, which is "growth." Gross Domestic Product growth in China may be slowing to 7.5%, but by my math that still portends an approximate 400,000 barrel per day (400 Mbblpd) increase in oil demand.
Nonetheless, some midcap stocks with market caps of under $1 billion (B) are growing production by over 50% with cash flow margins of over 50% and solid balance sheets. Yet they are trading under four times their enterprise value, which is very cheap. These strong underlying fundamentals and extraordinarily inexpensively priced stocks present a bit of a dichotomy.
TER: You've discussed general market sentiment, but what is your outlook? Are you bullish over the next 12–18 months?
EN: Yes I am. The world economy continues to grow, and the world oil market remains tight. We're eating through worldwide capacity, including some of OPEC's vapor barrels.
TER: Speaking of OPEC, political tensions between the U.S. and Iran seem to have created a premium in oil. Electoral politics further elevate these tensions. Could this result in a selloff in the period leading up to the November 2012 election?
EN: I would agree that there seems to be a political risk premium of around $15–20 built into the current oil price, although supply is in fact down about 800 Mbblpd since Iran sanctions were put in place. But as far as how the election may affect price action, my crystal ball isn't that clear.
TER: Do you expect your sub-$1B market cap companies to continue their pace of 50% production growth?
EN: Without question. Many companies have put on some hedges, and I'm a big proponent of that because investor risk tolerance has decreased since the 2008–2009 period. Hedging used to be a negative stigma for junior oil producers, the rationale being that if the price of oil went above their hedges, they'd be penalized; and if the price of oil dropped, the share price would still go down despite the protection of the hedges. In today's environment, people are more comfortable if an element of cash flow has been protected so that capex programs are guaranteed irrespective of the underlying commodity price.
That said, I'm looking at many of these companies that are sitting on 10–15 years of drilling inventory, and in parts of Canada they can get 5% royalty incentives for upwards of the first 60–80+ Mbbl oil produced, depending on the well. The first couple of years can be wildly economic. The situation is that there is a strong commodity price, and for companies with hedging in place and extended drilling inventory for 10, 15 or even 20 years, the outlook of that growth rate is well maintained.
TER: So is this the sweet spot in energy right now?
EN: That's a good question because it leads me to my current strategy. Even with the risk premium for oil prices we discussed, I feel that fundamentals will remain strong. Thus, I want to be invested in oil through the subset of roughly $300M–1B-market cap stocks that have been severely penalized in spite of the very strong price of oil in Canada.
With natural gas, however, the fundamentals are extraordinarily weak, and the outlook for the next several quarters looks bleak. I expect this summer to be extraordinarily volatile and weak for natural gas stocks. I don't think people appreciate just how terrible the current situation is and what's likely coming in the next couple of quarters. This summer, I expect the market to reach a point of maximum pessimism, with Canadian gas pricing below $1 per thousand cubic feet (/Mcf) and U.S. pricing below $2/Mcf. In a scenario of maxed-out physical storage, natural gas could become a no-bid. I think storage levels both in the U.S. and Canada will fill, and that may lead to a massive selloff. Ultimately, that could potentially lead to the investment opportunity of a decade.
TER: You're talking about classic economic theory, where a no-bid would halt production and a rebound would eventually follow.
EN: Yes. What's happened is that we've had the warmest winter in about 60 years. It's been an incredibly hot winter, which has led to very little heating demand in conjunction with, for a number of reasons, high levels of production. With demand so low, supply continues to increase, and now we are at a 900 billion cubic feet surplus, which is unbelievably shocking. Canadian storage today is around 83% full and we haven't even started the injection season yet. All things considered, it's just a terrible outlook for the next couple of quarters. And yet when you look at these natural gas stock prices, they're expensive. Even at a higher gas price, I still think the stocks are overvalued. I would not be surprised to see a selloff of another 10%, 20% or 30% in many of these names.
TER: How do you interpret rumors of possible Asian demand for Canadian natural gas, an eventuality many analysts are hinting at? For example, Bloomberg recently reported that the CEO of Malaysian, state-owned Petroliam Nasional Bhd (Petronas) says he wants to make a $5B Canadian acquisition in the next three months in order to secure natural gas supplies for Asia.
EN: In that case, I think people are misinterpreting what the gentleman meant. If you were sitting in his seat, the least logical thing to do if you're planning a corporate acquisition would be to foreshadow your move. What I think he meant is that he intends on forming a joint venture (JV) agreement with a company, such as an Encana Corp. (ECA:TSX; ECA:NYSE). I see the $5B number he mentioned was more of a reference to drilling costs; I'd be surprised if it referred to an outright corporate acquisition. There's a tremendous amount of product on the market right now, and given how capital-constrained many of these natural gas companies are today, the JV is a more likely scenario. Companies like ARC Resources Ltd. (ARX:TSX) and EnCana are aggressively looking for partners to assist them on drilling.
TER: Asian demand aside, what catalysts should investors be watching for if they want to participate in the possible buying opportunity in natural gas you discussed earlier?
EN: That's a great question. One may have to be patient, but the potential returns will incentivize being patient in terms of your investment time horizon. First of all, we'll likely have to wait for winter to get a sense of what the heating demand is for next year. Continued decreases in the natural gas-directed rig count would be another indicator. Finally, capitulation by investors in these stocks as they fall precipitously on very large volumes and in large blocks would be a key catalyst. People will just throw in the towel. The ultimate catalyst may even be gas going no-bid, when things frankly could not get any worse.
TER: Rock bottom, in other words. Do you have any closing thoughts?
EN: In summary, I would say the underlying fundamentals for oil remain strong, assuming the world doesn't slip into a global recession, which I think is very unlikely. Stocks have been extraordinarily weak over the past couple of weeks and months, but if one can be patient, these stocks represent a very good opportunity. As for natural gas, there will be a selloff in equities in the next couple of quarters, and investors need to have their shopping lists ready because these names are going to go on sale.
TER: Thank you, Eric. I enjoyed this very much.
EN: Likewise. Thank you.
Eric Nuttall is a portfolio manager with Sprott Asset Management (SAM). He joined the firm in February 2003 as a research associate and was subsequently promoted to research analyst in 2005, associate portfolio manager in 2008 and then to portfolio manager in January 2010. He is co-manager of the Sprott Energy Fund along with Eric Sprott, and also co-manages the Sprott 2010 Flow-Through Limited Partnership with Allan Jacobs. In addition to his responsibilities for those two funds, Nuttall supports the rest of the Sprott portfolio management team by identifying top-performing oil and gas investment opportunities. Further, he contributes towards internal macro energy forecasts, and his insight into emerging unconventional plays has been covered in several financial publications such as The Wall Street Journal, Asia and Barron's. Nuttall graduated with high honors from Carleton University with an Honors Bachelor of international business.
Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
DISCLOSURE:
1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services.
3) Eric Nuttall: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.
Eric Nuttall: There were several factors: First, the weather failed to cooperate in Canada, where we had a very extended breakup in southeast Saskatchewan. We had epic levels of rainfall. We also had raging forest fires in parts of Alberta. The weather led to a low level of activity for much of the first half of 2011, and many companies struggled to fulfill their capex programs and meet their production targets. Natural gas pricing was very weak, which is something that I expect for the remainder of 2012. Meanwhile, equity markets were very volatile. There were many different factors, all of which oil and gas companies had to contend with.
TER: You commented that despite the fact that, for the first time in history, the price of Brent crude oil averaged more than $100 per barrel (/bbl) during 2011, oil stocks languished. What was the issue here? Are markets fearful of negative global macroeconomic events?
EN: In a word, yes. European debt issues captivated the public's attention for much of 2011, specifically worries about Italy, Portugal, Spain and most obviously Greece. Today, those fears seem to have abated somewhat, but there's still a tremendous level of uncertainty. I think there's lingering psychological trauma from 2008 and 2009 that encourages people to approach the market from a fear-driven mode as opposed to a greed-driven mode, meaning the appetite for risk is very low. You can see that in mutual fund industry money flows, where the only funds that are really garnering large cash inflows are dividend- or yield-oriented funds. That indicates retail investors are still worried we'll have some unexpected event that will lead to a selloff similar to the one markets experienced in 2008 and 2009. Most people simply can't afford to endure another one of those.
TER: Let's shift our focus to oil price action. Oil is up about 3–5% over the past 12 months, but it's basically flat. Is this a period of consolidation? What does that mean for equities?
EN: It is a period of consolidation, and share prices today reflect that industry environment. Many stocks have descended well over 20% within the past two months. We've experienced a sharp selloff even though oil prices have remained very strong, and it feels like the market is oversold despite strong fundamentals. Although we had a poor U.S. employment number for March, I think people missed out on the operative word, which is "growth." Gross Domestic Product growth in China may be slowing to 7.5%, but by my math that still portends an approximate 400,000 barrel per day (400 Mbblpd) increase in oil demand.
Nonetheless, some midcap stocks with market caps of under $1 billion (B) are growing production by over 50% with cash flow margins of over 50% and solid balance sheets. Yet they are trading under four times their enterprise value, which is very cheap. These strong underlying fundamentals and extraordinarily inexpensively priced stocks present a bit of a dichotomy.
TER: You've discussed general market sentiment, but what is your outlook? Are you bullish over the next 12–18 months?
EN: Yes I am. The world economy continues to grow, and the world oil market remains tight. We're eating through worldwide capacity, including some of OPEC's vapor barrels.
TER: Speaking of OPEC, political tensions between the U.S. and Iran seem to have created a premium in oil. Electoral politics further elevate these tensions. Could this result in a selloff in the period leading up to the November 2012 election?
EN: I would agree that there seems to be a political risk premium of around $15–20 built into the current oil price, although supply is in fact down about 800 Mbblpd since Iran sanctions were put in place. But as far as how the election may affect price action, my crystal ball isn't that clear.
TER: Do you expect your sub-$1B market cap companies to continue their pace of 50% production growth?
EN: Without question. Many companies have put on some hedges, and I'm a big proponent of that because investor risk tolerance has decreased since the 2008–2009 period. Hedging used to be a negative stigma for junior oil producers, the rationale being that if the price of oil went above their hedges, they'd be penalized; and if the price of oil dropped, the share price would still go down despite the protection of the hedges. In today's environment, people are more comfortable if an element of cash flow has been protected so that capex programs are guaranteed irrespective of the underlying commodity price.
That said, I'm looking at many of these companies that are sitting on 10–15 years of drilling inventory, and in parts of Canada they can get 5% royalty incentives for upwards of the first 60–80+ Mbbl oil produced, depending on the well. The first couple of years can be wildly economic. The situation is that there is a strong commodity price, and for companies with hedging in place and extended drilling inventory for 10, 15 or even 20 years, the outlook of that growth rate is well maintained.
TER: So is this the sweet spot in energy right now?
EN: That's a good question because it leads me to my current strategy. Even with the risk premium for oil prices we discussed, I feel that fundamentals will remain strong. Thus, I want to be invested in oil through the subset of roughly $300M–1B-market cap stocks that have been severely penalized in spite of the very strong price of oil in Canada.
With natural gas, however, the fundamentals are extraordinarily weak, and the outlook for the next several quarters looks bleak. I expect this summer to be extraordinarily volatile and weak for natural gas stocks. I don't think people appreciate just how terrible the current situation is and what's likely coming in the next couple of quarters. This summer, I expect the market to reach a point of maximum pessimism, with Canadian gas pricing below $1 per thousand cubic feet (/Mcf) and U.S. pricing below $2/Mcf. In a scenario of maxed-out physical storage, natural gas could become a no-bid. I think storage levels both in the U.S. and Canada will fill, and that may lead to a massive selloff. Ultimately, that could potentially lead to the investment opportunity of a decade.
TER: You're talking about classic economic theory, where a no-bid would halt production and a rebound would eventually follow.
EN: Yes. What's happened is that we've had the warmest winter in about 60 years. It's been an incredibly hot winter, which has led to very little heating demand in conjunction with, for a number of reasons, high levels of production. With demand so low, supply continues to increase, and now we are at a 900 billion cubic feet surplus, which is unbelievably shocking. Canadian storage today is around 83% full and we haven't even started the injection season yet. All things considered, it's just a terrible outlook for the next couple of quarters. And yet when you look at these natural gas stock prices, they're expensive. Even at a higher gas price, I still think the stocks are overvalued. I would not be surprised to see a selloff of another 10%, 20% or 30% in many of these names.
TER: How do you interpret rumors of possible Asian demand for Canadian natural gas, an eventuality many analysts are hinting at? For example, Bloomberg recently reported that the CEO of Malaysian, state-owned Petroliam Nasional Bhd (Petronas) says he wants to make a $5B Canadian acquisition in the next three months in order to secure natural gas supplies for Asia.
EN: In that case, I think people are misinterpreting what the gentleman meant. If you were sitting in his seat, the least logical thing to do if you're planning a corporate acquisition would be to foreshadow your move. What I think he meant is that he intends on forming a joint venture (JV) agreement with a company, such as an Encana Corp. (ECA:TSX; ECA:NYSE). I see the $5B number he mentioned was more of a reference to drilling costs; I'd be surprised if it referred to an outright corporate acquisition. There's a tremendous amount of product on the market right now, and given how capital-constrained many of these natural gas companies are today, the JV is a more likely scenario. Companies like ARC Resources Ltd. (ARX:TSX) and EnCana are aggressively looking for partners to assist them on drilling.
TER: Asian demand aside, what catalysts should investors be watching for if they want to participate in the possible buying opportunity in natural gas you discussed earlier?
EN: That's a great question. One may have to be patient, but the potential returns will incentivize being patient in terms of your investment time horizon. First of all, we'll likely have to wait for winter to get a sense of what the heating demand is for next year. Continued decreases in the natural gas-directed rig count would be another indicator. Finally, capitulation by investors in these stocks as they fall precipitously on very large volumes and in large blocks would be a key catalyst. People will just throw in the towel. The ultimate catalyst may even be gas going no-bid, when things frankly could not get any worse.
TER: Rock bottom, in other words. Do you have any closing thoughts?
EN: In summary, I would say the underlying fundamentals for oil remain strong, assuming the world doesn't slip into a global recession, which I think is very unlikely. Stocks have been extraordinarily weak over the past couple of weeks and months, but if one can be patient, these stocks represent a very good opportunity. As for natural gas, there will be a selloff in equities in the next couple of quarters, and investors need to have their shopping lists ready because these names are going to go on sale.
TER: Thank you, Eric. I enjoyed this very much.
EN: Likewise. Thank you.
Eric Nuttall is a portfolio manager with Sprott Asset Management (SAM). He joined the firm in February 2003 as a research associate and was subsequently promoted to research analyst in 2005, associate portfolio manager in 2008 and then to portfolio manager in January 2010. He is co-manager of the Sprott Energy Fund along with Eric Sprott, and also co-manages the Sprott 2010 Flow-Through Limited Partnership with Allan Jacobs. In addition to his responsibilities for those two funds, Nuttall supports the rest of the Sprott portfolio management team by identifying top-performing oil and gas investment opportunities. Further, he contributes towards internal macro energy forecasts, and his insight into emerging unconventional plays has been covered in several financial publications such as The Wall Street Journal, Asia and Barron's. Nuttall graduated with high honors from Carleton University with an Honors Bachelor of international business.
Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
DISCLOSURE:
1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services.
3) Eric Nuttall: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.
