The Great Waiting Game

The Sprott Energy Fund is a long-term capital growth fund which invests primarily in equity and equity related securities of companies involved in exploration, development, production and distribution of oil, gas, coal, or uranium, and other related activities in the energy and resource sector.

Each month The Sprott Energy Fund releases a monthly commentary.  For their February 2017 Commentary, portfolio Manager Eric Nuttal digs into why oil stocks are falling, asks the question of whether it will turn to a bull market for oil, and basically addresses all things oil.

Here is the commentary titled “The Great Waiting Game.”

The Great Waiting Game

The first two months of the year have been pretty awful for energy investors. Though the price of oil is slightly positive year-to-date Canadian oil stocks have fallen by 15%+ and US oil stocks have fallen by 5%+. What gives? Why are oil stocks down while oil is up? Do we still believe in $60/bbl oil this year? Is this the end of the bull market for oil? Have we raised cash given the sell off? What happens if a Border Adjustment Tax does go through? We will do our best to address all of the above.

Oil stocks have clearly been underperforming the underlying commodity. Why? To answer that we need to distinguish between the Canadian market and the US market. Specific to the Canadian market worries about a Border Adjustment Tax and the loss of competitiveness for foreign capital to the US has kept Canadian oil names under pressure. Further adding to this selling pressure has been the reemergence of strong production growth expectations from US producers which has made many (but not all) Canadian oil companies relatively unattractive compared to their US counterparts. On an adjusted basis the average Canadian intermediate company is expected to grow production by about 14% in 2018 and trades at 5.6X EV/EBITDA. Contrast this with the expectation that the average Permian producer will grow production by nearly 40% and trades at 7.0X EV/EBITDA. Debates can be made about long-term value creation and “growth for growth’s sake” however in the short-term it is the sexier growth rates in the US that will attract capital and hence why US investors are not rushing back to the Canadian market (oh and a carbon tax, lack of pipeline takeaway capacity, total inaction at a Federal and Provincial level, First Nations issues, etc. don’t help either). Why then are even US oil stocks underperforming oil? The reason is that for most generalist investors in the US the energy sector is irrelevant unless there is a strong reason to have capital deployed in it. This is because in contrast to the TSX 60 where energy accounts for about 20% of the index in the S&P500 it is only 6%. As oil has been stuck in a tight trading range so far this year (has touched or briefly gone through $54/bbl 6 times so far this year) and non-energy specialists are bombarded with headlines about an oversupplied oil market (factually incorrect) and US oil supply growth (consensus is far too optimistic) money hasn’t found its way into energy stocks yet, especially when other sectors like financials and technology are doing so well (Dow and S&P at all-time highs…energy investors sure wouldn’t know it!). So what has to happen for this to change?

The core of our thesis is that the oil market entered into a state of undersupply beginning in July 2016 when global oil inventories finally began to fall. This trend was further magnified by OPEC’s decision to curtail over 1MM Bbl/d of production and other non-OPEC producers by over 0.5MM Bbl/d effective January 1, 2017. However the acceleration of the oil market’s tightening hasn’t been felt yet in the US since it takes 45-60 days for an oil tanker to leave the Persian Gulf and reach the US Gulf Coast. Even though the US only accounts for ~ 25% of global inventories (and the other 75% of the world’s inventories have been falling) the oil market has been myopic in its absolute focus on the US mainly due to the fact that it is the only area where timely information gets released on a weekly basis. As well, since it is the only major area of production growth globally in 2017 the US will be the last area to rebalance. The price of oil then will move with the trajectory of the over/undersupply of this market. In the coming days/weeks as the impact of OPEC’s production cut is finally felt in the US we believe the price of oil will break out of its trading range thereby drawing capital back into the space. That will signal the beginning of the next run up in oil and will quickly bring money back into oil stocks (positive performance will beget more positive performance as the opposite is true today). Until then, we patiently wait by keeping our eye on the upside (more on that below).

The start to 2017 has an eerie resemblance to the start of 2016 when the market was in a pessimistic rut, energy stocks were in freefall, everyone had become an oil expert, and no one wanted to buy energy stocks (other than us). We took a slightly different approach. We felt that given the pummeling in the names and the massive groupthink that was ongoing that the risk: reward favoured being fully invested (ie. 0% cash). While our timing was not perfect we were rewarded with a 100%+ rally from the lows. Today we feel the same way. Energy stocks have been brutalized in the first 2 months of the year by sector rotation, lack of visible evidence of falling US oil inventories and by extension the acceleration in the rebalancing of the global oil market (doesn’t mean it hasn’t been happening), massive groupthink about the pace of US supply growth (too optimistic), the likelihood of OPEC cheating (too pessimistic), and Trump’s twitter rants that have been creating added volatility. Despite all of this when we tune out the noise we see an oil market that can still reach normal levels by the end of the year (demand is up strongly, OPEC compliance is at a record high, non-US/OPEC supply is stagnating, and meaningful US supply growth will take longer than people expect). This remains the reason why we believe oil will hit $60/bbl by mid-2017. Our experience from last year was that when sentiment turned it happened quickly and violently. Had we not been fully invested we would have missed most of the rally as it happened in a matter of days (pull up the WLL US chart and see what it did in early March 2016…gapped up 20% a day for 3 days in a row!). This means that while stomaching the daily volatility from being fully invested is not pleasant (especially with a weighted portfolio beta of 150%) we own companies where we see enormous upside: the average upside in our names is now 55% and is nearing the upside that we saw in January 2016. In short, the risk has once again become greater in NOT being invested in the space. We’ve put our own money where our mouth is and have made a highly significant personal investment into the Fund in recent weeks.

So how are we positioned to maximally benefit for the imminent turn in sentiment? We own 16 names of which 6 are Canadian and 10 are in the United States. Our 16 holdings are made up of 10 oil companies, 5 service companies, and 1 natural gas company. You’ll note that despite our belief that the “border adjustment trade” will yield a positive move in Canadian oil stocks we have been adding to our US oil exposure. We are simply finding better opportunities at the moment South of the border: our US names on average are expected to grow production by 50% this year and by 40% in 2018 versus the average Canadian intermediate growing production by 20% this year and 15% in 2018. While valuations are slightly higher (7.0X 2018 EBITDA in the US vs. 5.6X in Canada) we find the overall attractiveness of many US names to be superior. We are most excited about the profit  potential  in  our  5  service  companies as we have identified two areas of the service sector that are garnering pricing power: pressure pumping and frac sand. Both of these areas are experiencing a strong rebound in demand and consequent pricing that is up over 20% from the lows of a few months ago. As analysts are too slow to react to such a dynamic move (and are terrified about being wrong) consensus EBITDA estimates for 2017and 2018 are too low. We see 50%-100% upside in our 5 service holdings and have taken advantage of very recent confusion surrounding one frac sand company’s plans to expand production by making one particular company one of our largest holding (9.3% weight). These are the moments in which you can make part of your year so long as you correctly identify them and take a bold position.

In closing I would like to reiterate a few key things. First, while the crummy performance so far this year is frustrating (especially when every other sector is doing well) we strongly feel that patience will be rewarded. The turn in sentiment is close at hand and if our experience from last year plays out again in 2017 it will happen so quickly most people that are not already invested will completely miss it. We have put our own money on the line by making a very sizable recent investment in the Fund. Secondly, we are in a multi-year bull market for oil: inventories globally are falling, demand is strongly growing, OPEC is out of further capacity after the shut-in volumes get returned, the US will take longer and require a higher oil price to ramp production back to its historic 1MM Bbl/d per year of growth, and given the sharpest drop in spending in history on large scale mega projects Non-US/OPEC producers in aggregate cannot meaningfully grow production in 2018-2020. Third, if a Border Adjustment Tax does go through that includes oil we would expect the Fund to be a net beneficiary given our increased US exposure (and the US names are baking in a zero % chance anyway so we do not see downside if we are right about the BAT). Fourth, we are the worst performing Energy Fund year-to-date and this is by design. We are purposefully holding higher beta names at the moment as we think they have enormous upside in the short-term. It would be easy to hide out in pipeline stocks and Suncor right now given the direction of the market but in doing so we would be immune to again what we see as extremely favourable risk: reward. The average holding in our Fund has an estimated 55% upside. We’ll end on that. For now (days or weeks) we are in the Great Waiting Game… patience will be rewarded.

Eric Nuttall Portfolio Manager Sprott Energy Fund