With the exception of 2016, it’s been five long years of misery in the energy patch. Yet energy specialist Jennifer Stevenson argues that the sector is now on a firmer footing and there is some cause for optimism. Moreover, given the macro-economic fundamentals, prospects are looking up for investors who have patiently waited for a turnaround.
“When you look through the noise in the market, which is often caused by concerns about China trade wars or about economic growth, and you actually calculate things like supply and demand and costs, it [energy] is a very healthy business,” says Stevenson, Calgary-based vice-president at 1832 Asset Management LP, and lead manager of the 4-star, gold-rated $244.9 million Dynamic Energy Income Series F.
“We have been through a long enough downturn that any excesses or unnecessary costs are well and truly cut out of the business. It can generate free cash flow at what are deemed to be low commodity prices. At US$45-55 West Texas Intermediate [WTI] per barrel, good companies can generate free cash flow. That is entirely different from what we had 10 years ago. They are making more money at a lower price because their costs have fallen.”
Stevenson joined 1832 Asset Management in 2010, after spending 14 years in energy investment banking and on the sell-side and earning an MBA from University of Alberta in 1994. She regards the energy sector as a more mature business as opposed to one that was wedded to the notion of growth at all costs. “A few years ago, you were rewarded for being a growth company and it was all about top-line growth, and not bottom-line growth, or returning cash to shareholders. That’s because shareholders were benefitting from share price appreciation as the growth went up. They didn’t worry about a company’s metrics. The metrics became secondary.”
The lengthy downturn has forced companies to look inwards and fix their business models. “Now we have a sector that can attract investors. Yes, there is some cyclicality. But when you look through that, and over time, you can see that it is a free cash-flow generating business. You can be a long-term investor or try to pinpoint the cycles, and trade around them. At the end of the day, though, it’s all about steady low-growth shareholder return businesses. You want things to march upwards.”
There’s already been a bit of a recovery as year-to-date Dynamic Energy Income is up close to 12%, compared to a loss of 14.2% in 2018 and 2.75% in 2017. The question is, can the recovery continue? Stevenson believes it can, based on a several factors.
“The fourth quarter reporting and guidance for 2019 will show a continued demonstration of prudent capital allocation, returns-based investing, and cash returns to shareholders,” says Stevenson. “The question is, with WTI at US$50-$55, which has been tested as a reasonable floor price, can you cover your sustaining capital and some growth capital to allow your business to grow by a mid- to high-single digit amount? And can you cover the dividend and also grow it? The more boxes that you can check off, the better share price appreciation you will have.”
One of the biggest challenges has been excessively high global oil inventories, which began to grow in 2015. But they have been coming down, which in Stevenson’s view sends a bullish signal. “In 2018, we drew them down below the five-year average,” says Stevenson, noting that inventory levels are a key indicator about the supply-demand relationship. “That was a real signal to the market that things were tightening up and it led to strength in oil prices and that was reflected in improving share prices. That will happen again this year.”
Meanwhile, as additional pipelines in Canada have been relegated to the sidelines, Stevenson argues that railways will make a difference in terms of delivering crude to markets. “The government of Alberta curtailed production to help reduce differentials,” says Stevenson, referring to the price differential between Western Canadian Select and WTI. She points out that WCS is a lower quality crude, and the differential also reflects the cost of transporting crude oil long distances.
Since Alberta’s royalty calculation is based on the cost of the marginal barrel and WCS fell to about US$12 a barrel the province took a big cut in royalties. “It had a major impact,” says Stevenson. But the government-ordered production cutback has boosted royalties again and “fixed the differential to the point that it is now about US$12.” In addition, Stevenson notes that it costs about US$18 a barrel to transport oil by rail to refineries on the U.S. Gulf coast.
“This [situation] will normalize over the next few months,” Stevenson adds. “Rail will make a difference because it represents the marginal barrel that is setting the price of the differential. If that marginal barrel can get into a railcar then the differential will be economically-viable.”
From an investment standpoint, Stevenson is favoring a select group of large-cap producers and pipelines, with an average market-cap of $25 billion. Dynamic Energy Income, which owns about 25 stocks that generate dividends, has a running income yield of about 6%, before fees. “I want that dividend to be sustainable and to grow as commodity prices improve,” says Stevenson, adding that the dividends can continue to be paid even when commodity prices are low.
Stevenson also manages the 4-star gold-rated $24 million Dynamic Strategic Energy Class F, which focuses on quality companies and sustainability of earnings, but are not expected to pay dividends.
Fully invested, Stevenson has split the portfolios roughly between 33% in Canadian stocks, 50% U.S. and about 17% in international positions. She uses a stock selection methodology known as QUARP (trademarked), or quality at a reasonable price. While quality of assets and balance sheet strength are key attributes, management is paramount. “If management does not pass on the basis of track record, strategy, shareholder focus and personal investment, then forget it. Management is number one.”
One top Canadian holding common to both funds is oil sands producer Suncor Energy Inc. (SU). “It has a long reserve life, because the real benefit of the oil sands is that you are not fighting declines,” says Stevenson, referring to the challenge of diminishing reserves many energy firms must confront. The stock is trading at 6.5 times enterprise value (EV) to earnings before interest taxes depreciation and amortization (EBITDA). Stevenson believes the shares are trading at a 25% discount to net asset value.
Another favorite is TransCanada Corp. (TRP), one of the largest pipeline firms in North America. “It has growth in its gas business in the U.S. and in Canada. And it has the ‘optionality’ of long-term pipeline growth when things like Keystone Express get done. It’s not reflected in the share price---yet,” says Stevenson. Shares, which are trading at 11.5 times EV to EBITDA, are paying a 5% dividend.
Looking ahead, Stevenson maintains that inventories may be falling but production may not be sufficient to keep up with global demand. “I worry that after four or five years of a downturn, and little re-investment, by 2020-21 people will start to ask, ‘Where’s the oil?’” says Stevenson, noting that large-scale projects, which take five years or more to bring on stream, have been few and far between. “There will be growth in populations and economic growth. That will ultimately benefit energy investors.”
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