There may be positive economic news coming out of Ottawa — such as record-low unemployment levels and the recent better-then-expected GDP report — but in Alberta, you would hardly know it.
The mood here is downright terrible. Besides the 30 per cent vacancy rates in downtown Calgary, the province is facing oil prices that have collapsed 22 per cent over the past 12 months and are down more than 44 per cent in the past five years.
As a result it’s been complete carnage in the sector with the Capped Energy index down over 36 per cent in the past year and a whopping 58 per cent over the past five years. A number of junior and intermediate producers have seen their share prices hit even harder, with declines of as much as 75 to 90 per cent.
To add some further perspective, the energy sector is so oversold that according to Incrementum AG, the commodities-to-S&P500 ratio is now at 0.82, a level not seen since the lows in 1972 and 2000.
However, we believe we see a light at the end of what has been a very dark tunnel which is not only good news for Western Canadians but also one heck of a potential opportunity for those investors brave enough to position for the recovery.
The turning point, in our opinion, was the U.S. Federal Reserve’s decision last week to cut interest rates. We think oil prices should respond quite favourably and more quickly than many expect as global central banks begin easing and stimulating economies once again. This could especially be the case in emerging markets with another huge catalyst being some form of trade resolution between China and the U.S.
For example, take a look at when banks began to tighten in 2017 and oil demand among the Top 15 oil consumers globally went from a two per cent year-over-year gain to a two per cent year-over-year loss, bringing oil prices down from $78 per barrel to $52. Given that level of elasticity, imagine what the upside will be should these consumers shift back to historical levels of growth?
However, the level of negativity in this recovery is so pervasive that it has sent oil and gas companies to levels I have rarely seen in my career, even when I was an energy analyst and oil prices were at $20 a barrel.
As a result we’re witnessing those companies even with fantastic management teams, strong balance sheets and well-diversified high-netback production streams, trade at $20,000 to $40,000 per BOED, and 2.5- to four-times cash flow. Based on my experience, these parameters have historically been more than double where they are now so it would be fair to say investors are discounting much lower oil prices in their forward valuations.
So what happens to these share prices when investors begin to reflect current oil prices into valuations or better, higher oil prices as global demand expands?
In the near-term, one can own blue chip senior and integrated producers both here in Canada and abroad with a near FIVE per cent dividend yield — think about that. Going down the food chain into the intermediates, some well financed producers with reasonable payout ratios are currently paying seven to 12 per cent dividends.
There are some fund managers arguing that these companies should be buying back their stock at these levels, and we somewhat agree, but overall we prefer dividends as they provide more flexibility for investors to reallocate as they so choose.
Jumping back into the energy sector is a trade that isn’t without risk, but for those currently underweight, perhaps it’s worth having another look given the situation that is unfolding.
Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.
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