‘We’re through the valley of death’: Oil investors more optimistic, but sector still faces uncertainty

Crude oil prices may have surged back above US$33 in recent days, bringing a new wave of enthusiasm to Canadian energy stocks, but market watchers are still divided on what direction the sector will head next.

The strength in May follows an April that was, by far, the worst month on record for oil. West Texas Intermediate dropped into negative territory for the first time on record, falling as low as -US$40 due to a lack of short-term demand. Oil was in a severe contango, meaning that prices for futures contracts were higher than spot prices.

The future looked grim, at least until investors began growing more optimistic about an economic recovery that could lead to a normalization in demand. It helps that the price war between Saudi Arabia and Russia, which sent prices into self-destruction, has cooled and that OPEC has issued production cuts of 9.7 million barrels per day.

That enthusiasm spilled over into Canadian oil stocks as the S&P/TSX Capped Energy Index has rallied 25 per cent since WTI prices bottomed. On Tuesday, names like Suncor Energy Inc., Canadian Natural Resources Ltd. and Cenovus Energy Inc. each closed more than four per cent higher.

“We’re through the valley of death,” said Eric Nuttall, a portfolio manager at Ninepoint Partners. “We’re no longer in an oil-price environment where you have to worry about near term bankruptcies for the patch.”

Nuttall sees a bull market developing for energy stocks, even after some small- and mid-cap names have already bounced more than 100 per cent from their bottoms. The setup for another surge in 2021 is already in place: supply is going to be tighter because of production cuts, OPEC is going to continue to attempt “to move heaven and earth” to boost prices and offshore production is plateauing, he said.

Any other positive news that suggests society may be closer to returning to pre-COVID-19 function — a vaccine or treatment for the virus that looks promising, the lifting of lockdown restrictions or a pick-up in air traffic — could continue to fortify oil prices, he said. He expects prices to hold in the US$30 range for the next few months and hit US$50 in 2021.

Energy stocks will fare better, he said. The challenge for investors is to pick the winners, given that there aren’t many differences between the producers at the moment.

“The best companies are trading at similar valuations as the worst,” he said. “There’s no differentiation between balance sheet strength. There’s very little differentiation between management and product quality. It’s more been trying to figure out the overall direction of the market.”

There’s risk associated with names across the sector, he said. Some of the small caps are among the worst year-to-date performers, but their balance sheets are often problematic and liquidity is a concern. While that is currently less of an issue for large caps like Suncor and Canadian Natural Resources, they’ve accrued negative cash flow throughout the crisis and therefore their balance sheets won’t emerge from it with the same position of strength.

Nuttall owns Cenovus, but his preferences lean toward the small- and mid-cap names in the sector. He likes MEG Energy Corp., which is still down 60 per cent, as well as Whitecap Resources Inc. which is 67 per cent off its 52-week high. The average holding in his fund is down 65 per cent, he said.

Some names have already more than doubled and still have that much ground to cover. A lot of the easy money has already been made and so it might not be reasonable to expect another double in a month or two, said AltaCorp Capital analyst Patrick O’Rourke.

Neither the stocks nor the commodity are out of the woods yet, he said. Crude in the US$30 range isn’t cause for celebration. With oil prices at that level, producers are just barely avoiding an operations loss.

O’Rourke is focused on companies with strong capital structures and lower-cost operations, and while most are still lagging far behind their pre-COVID-19 highs, they still could be solid long-term investments. For example, O’Rourke likes the potential in Seven Generations Energy Ltd., a natural gas play, as compared to other mid-cap E&P stocks.

It’s also important for retail investors to shift their expectations for these stocks. Their dividends have been slashed in the crisis and so they should no longer be looked to as income generating stocks. If they’re going to be bought, it should be for their growth potential, said O’Rourke, who warned that reaching their former highs will be a slow burn.

“It’s going to require some patience,” O’Rourke said.

Source: Financial Post