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Sprott
Energy Fund Portfolio Manager Eric Nuttall wants an edge when he can find
one. He's bullish on oil, but he prefers to play the good oil story, not the
commodity. And even though he's bearish on natural gas, he's finding names
that may provide exceptional growth. Eric shares his best ideas in this
exclusive interview with The Energy Report.
Companies Mentioned: Apache Corporation - Bankers
Petroleum Ltd. - Cheniere Energy Partners L.P. - Encana Corporation - EOG
Resources, Inc. - Legacy Oil & Gas Inc. - Open Range Energy Corp. -
Painted Pony Petroleum Ltd. - Suncor Energy Inc. - Vero Energy Inc. -
WestFire Energy Ltd.
The Energy Report: In 2010, the Sprott Energy Fund
outperformed its peer S&P/TSX Capped Energy Index (32.6% versus 11.7%).
In fact, the fund outperformed the index in five out of the last seven
calendar years. What's the formula here?
Eric Nuttall: We really try to look for opportunities where we have an
edge over our competitors. That typically leads us into the small- and
mid-cap energy space, where we think the outlook is very positive over the
next couple of years. We believe the fundamentals for oil are now very solid.
And we think there's been a huge disconnect in the performance of oil and gas
(O&G) stocks relative to what the commodities have done.
TER: You're bullish on oil. Tell us why.
EN: What I fall back on is supply and demand data, which I find to be
very reliable. Despite an increase in weak economic data points in several
developed economies, I still believe that the world oil market will tighten
heading into the fourth quarter of this year (Q411). We entered 2011 in a
state of being undersupplied by about 1 million barrels of oil per day
(MMbpd). So, it wasn't a surprise to me back at the last OPEC meeting that
Saudi Arabia was trying to increase actual production by about 1 million
barrels. The recent release from the Strategic Petroleum Reserve (SPR) is
nothing but a politically motivated move to try to suppress the price. While
this may create a ceiling of around $90/bbl for the next several months,
demand has been surpassing supply and the market is becoming increasingly
tight.
The oil demand story is about emerging economies. China was responsible for
33% of incremental demand in 2010, and in the most recent data from May,
demand is up 13% year-over-year (YOY). China now consumes more than 9 MMbpd,
a net change of over 1 MMbpd. I'm looking for demand destruction in the
developed economies; however, incremental net demand out of China, India and even
parts of Africa more than outweighs that demand destruction. The oil market
is tight today, and I think that it'll continue to get increasingly so.
Today, we consume 89 MMbpd globally; if the world continues to increase
demand by roughly 1–2 MMbpd per year, it's very easy to see a scenario
in which OPEC spare capacity could get down to 1 MMbpd within the next two
years. In that environment, I think the price of oil has to go higher.
TER: When you last spoke to The
Energy Report in the fall of 2010, you said that equity
valuations—not commodity prices—would be your guide. Since that
time, Brent Crude is up about $30/bbl or about 40%. Have you become a bit more commodity-driven since then?
EN: I wouldn't say so. I think Brent is a more relevant benchmark to
use than is West Texas Intermediate (WTI) because of the landlocked-storage
issues that Cushing, Oklahoma has been experiencing. So, when I look at a
$105/bbl Brent price, it tells me that world oil demand is very, very strong.
But at the same time, my forte is not top-down analysis of the commodity
markets—it's trying to find mispriced stocks. I personally believe that
global supply and demand now support a price of approximately $100/bbl WTI,
so you could call it about a $110/bbl Brent price. I think that price level
is defendable for the next couple of years, with an upward bias toward maybe
$5–$10/bbl per year.
In that environment, I think there are some incredibly cheap oil stocks in
the sub-$2 billion market-capitalization range that are trading at under 4x
enterprise value to cash flow (EV:CF); they are growing production by 30%,
40%, 50% per year and they have very clean balance sheets and a lot of
exposure to emerging plays. It's the best of all worlds. You've got
dirt-cheap stocks with a tremendous amount of upside. The amount of fear in
the marketplace today is the highest I've seen since 2009. One of my best
lessons from the Great Recession is that where there's fear, there's
opportunity. I think there's a tremendous amount of opportunity in this
subset of the market right now.
TER: Then, clearly, you are finding compelling valuations.
EN: Without question.
TER: And we'll get to that, but let me bridge to this. Are you currently
bearish on natural gas?
EN: I am. I believe that it's going to be capped at around $5/Mcf
(thousand cubic feet). I think we're stuck in a $4–$5/Mcf trading range
until 2015, at which time North America will become an exporter of natural
gas. In Canada, the Kitimat LNG (liquefied natural gas facility) will be
constructed by around 2015. Kitimat is jointly owned by Apache
Corp. (NYSE:APA), EOG Resources Inc. (NYSE:EOG) and Encana
Corp. (TSX:ECA; NYSE:ECA). In addition, Cheniere
Energy Partners L.P. (NYSE.A:CQP) got expanded approval to be a natural
gas exporter. I think we're going to see a lot more regasification
facilities on the Gulf of Mexico seek approval to become exporters.
Technology has unlocked an unbelievably large amount of natural gas that is
now quite economic at low prices. Four or five years ago, I would've said the
required price to achieve a decent economic threshold was $7/Mcf. Today, I
think that threshold is about a $4–$5/Mcf price among most of the shale
plays, which would be Eagle Ford, Haynesville
and Marcellus—the largest sources of new supply in both
the United States and North America. Rig count has continued to expand in all
of those plays. Even in a depressed natural gas price environment, producers
continue to drill.
Demand is growing as a result of coal substitution and lower nuclear power
plant utilization, but l still think supply is overwhelming demand. Again,
until we become an exporter, we're looking at a $5/Mcf ceiling price because
if we ever get above that, every single gas company in North America will be
trying to hedge to be able to lock in a very active capital-expenditure
(capex) program.
TER: So, you're saying there's a real arbitrage opportunity for some
nat gas producers to export to Asia and Europe?
EN: Yes, there's a huge arbitrage in that. The global LNG pricing on
average has been around $10–$12/MMBtu (million British thermal units).
There are times when it spikes due to seasonal factors, but there's a huge
price differential. That's why I think the plays that are close to key export
terminals are going to become highly strategic. Some of my top holdings are
companies involved in what I think will become increasingly strategic areas.
TER: For many reasons, energy has been a natural growth sector. How do
investors play this today?
EN: I look for companies in which I think I have an edge in my
analysis to determine if they truly are undervalued, or whether they're just
value traps. Because we've seen names fall 10%–15% in May, and then by
another 15%–20% in June, you could almost throw a dart at a board and
make money in the energy sector over the next couple of months. But where I'm
finding value, and where I think you get the best risk/reward, is in
companies that are levered to oil that are in that sub-$2 billion market-cap
space. There are also opportunities in the natural gas space. In a
$4–$5/Mcf gas-price environment, some companies are earning about a 75%
margin. I'm looking where the risk/reward of an investment opportunity is
highly, highly skewed to the upside.
TER: Skewed to the upside. Could you give me an example of that?
EN: Well, we could walk through some of my top holdings. That's
probably the best way to understand my style.
TER: Sure.
EN: In terms of size, my largest current position is Legacy Oil
& Gas Inc. (TSX:LEG). It's a $2 billion-market cap light oil company,
and it's a case study of how we try to look at things differently. There was a management change within a major shareholder, Fidelity
Investments, and the manager had to blow out 18 million shares. That took the
share price from $17.50 down to around $11.50; not for any fundamental
reason—it was due to fund flow. The stock trades at around $12 today,
but I was aggressively buying at around $12.50 and was buying every share I
could at around $11.50.
When I started buying LEG, I was paying the lowest multiple of price-to-cash
flow in its corporate history. and I thought my downside was limited to
commodity and market risk. I knew the company had very significant exposure
to several emerging plays, including the Spearfish in North Dakota and the Alberta Bakken, which is an emerging tight oil play. So,
I paid a very low multiple and got all of the upside free. I could see the
stock at $16. So, while a 33% upside from today's level doesn't sound super
sexy, it's decent; and I think my downside risk is very low. The company is
managed by, in my opinion, one of the best light oil teams in the business, which
is comprised of proven value creators; and the balance sheet is very clean.
TER: I note the company went from operations cash flow of $26.3M in
Q110 all the way up to $43.9M in Q111. Can that kind of growth continue?
EN: Yes, I'm looking for more than $300M cash flow in 2012. That would
put the company at 6.7x cash flow today, and I think it can grow production
by 15%. Legacy's about 80% levered to the price of light oil. It's got all of
the different aspects I look for.
My second-largest position is Painted
Pony Petroleum Ltd. (TSX.V:PPY.A), and this is an example of how you can
be bullish on natural gas names without necessarily being bullish on natural
gas. The company has a market cap of about $700M and, in terms of production,
it's equally split between oil and natural gas. Painted Pony has assets in
Saskatchewan, which is typically a light oil-weighted basin, and northwest
British Columbia, which is a real upside. But what I really liked is its very
clean balance sheet; this is a very debt-averse company. PPY has a five-year
drilling inventory in the southeast region of the Saskatchewan Bakken play, where
the economics or hurdle rate for the required price of oil is very, very
low. When I started buying the stock, it was trading very cheaply on current
production. Legacy appears to be in the sweet spot of the Montney Shale
play in Canada. I think fair value on existing production is up to $30, but I
don't think the company will be around long enough to realize that.
TER: So, 175% upside from here?
EN: Again, I don't think it will be around that long. It could be
easily taken out from $17.50–$20/share over the next year or two.
Internally, I think fair value is around $20/share. So, I'd be comfortable
saying it's close to 100% potential upside.
My third-largest holding is WestFire
Energy Ltd. (TSX:WFE), which is almost a pure play on an emerging tight,
light oil play called the Viking
Formation in Canada. The company has spent several years aggregating
acreage in this play, and I believe it has about 800 risked locations. If one
believes in $100/bbl oil, then that works out to about $25 of risked value
per share—and the stock is trading at $6.85 now and at 3.9x 2011 cash
flow. It's very, very cheap on current production. WFE's balance sheet is
healthy, and I think production will grow by more than 20% in 2012 over 2011.
I like the management; the team members have a lot of their own skin in the
game, so they're highly motivated to sell the company when the right time
comes.
TER: WestFire was your largest holding at the end of May, was it not?
EN: It would've been a few months ago. I haven't sold any shares. It's
been weak relative to a couple of other names.
My fourth-largest holding is a company called Open Range
Energy Corp. (TSX:ONR). This is an interesting name because if we had
talked nine months ago, I would've told you it was an economic natural gas
company that was growing production strongly. But what's really transformed
the story is a very positive uptake on a new service business called Poseidon
Concepts. It's simply a way to store water that's used to fracture stimulate
natural gas wells. What it's created is almost like a very large, inflatable
aboveground swimming pool, as opposed to hauling 20 or 25 truckloads of steel
tanks. So, there's a cost savings to ONR of more than $100,000 per job.
This business has grown from nothing to a run rate of about $80 million of EBITDA, which is just
phenomenal. So, that service business is growing strongly and the free cash
flow from it is being used to grow the natural gas business in the Wilrich,
where there's phenomenal natural gas economics. The company has very strong
growth on the natural gas business and, at the same time, there's very good
uptake on the service business. And, it's dirt cheap.
TER: You're a real value seeker, aren't you?
EN: Well, it's important to distinguish between a value stock and a
value trap. A value stock can be a cheap stock with
no catalyst to revalue the company. I always look for names where I think my
downside's limited because it's trading at a cheap multiple based on current
production. At the same time, there has to be some catalyst to the
name—otherwise, the stock can languish at a cheap multiple for years.
Sometimes cheap stocks are cheap for a reason; my job is to try to find those
opportunities where, in my opinion, the market is looking at something
incorrectly.
TER: You were going to mention another one?
EN: After Open Range would be Bankers
Petroleum Ltd. (TSX:BNK). It's fallen from a high of $10 around the
beginning of March to near $7, and so the stock's down 30%. At the same time,
it's marked off of Brent oil, and it's developing the largest onshore oil
field in Eastern Europe, the Patos-Marinza field in Albania. Bankers is
producing around 12,000 bpd, and will be exiting at around 18,000–20,000
bpd at the end of this year. It's been very successful at employing Canadian
technology in an old field to rehabilitate it and to grow production,
primarily using horizontal wells with good success.
TER: Again, it's under a $2 billion market cap, which is where you're
comfortable.
EN: Yes, it's that sweet spot. Larger companies are very difficult.
With a Suncor
Energy Inc. (TSX.V:SU; NYSE:SU) or an Encana, which is a $40–$50
billion market-cap company, it would be very difficult for me to have an edge
over my competitors. If I buy that company, I should expect to do as well as
the index. My unit holders are not paying me to perform as the index would.
They're looking for me to beat it. I'm looking for opportunities in which
I've got edge and that will typically lead me to a sub-$2 billion market.
TER: Do you want to mention one more company?
EN: Another one would be Vero Energy
Inc. (TSX:VRO), which is a stock that's kind of fallen out of favor with
the marketplace. The management's done a very good job of growing production
over the years. On a production-per-share basis, it's upward of around 22%
from 2009 until now, yet it trades at a low multiple. VRO's trading sub-4x EV
to cash flow, despite management's pretty good execution. Production is
growing very meaningfully, and the company is increasing the component of
liquids in the production stream. My hope is that Vero will sell itself at
some point this year or merge with another company creating
a high dividend-paying corporation and one exploration entity that the
Vero management team could lead.
TER: Eric, these are very interesting names. Thank you very much.
EN: 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. Eric is lead portfolio manager of the Sprott Energy
Fund, along with Eric Sprott, and he also comanages the Sprott 2010
Flow-Through Limited Partnership with Allan Jacobs. In addition to his
responsibilities for those funds, Eric supports the rest of the Sprott
portfolio management team in identifying top-performing oil and gas
investment opportunities. Eric also contributes to 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. Eric graduated with high honors from Carleton
University with an Honors B.S. in international business.
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