Jody Chudley says oil prices should recover in the latter half of 2016, and when they do, these oil- and gas-related equities are poised to do well
BY JODY CHUDLEY
It’s hard to win when you don’t know the rules of the game. I had thought that if oil prices were to suddenly collapse, Saudi Arabia and their Gulf compatriots would be willing to step in and remove enough production to support prices. Obviously I was wrong, but I think the second half of 2016 will finally bring a significant oil price recovery.
My belief is that while there is unquestionably a huge amount of oil sitting in inventory globally, that “glut” has not been growing much over the past six months. I believe that daily global supply and demand haven’t been that far out of balance for quite a few months now.
The inventory “glut” was created in the first six months of 2015 when there truly was a significant daily oversupply. The second half of 2015 through April 2016 has been pretty much balanced and by this summer inventories around the globe should start falling as there is a daily supply shortfall. When those inventory levels start falling I think it will really start pushing oil higher.
Below are four oil-related equities that I think will do very well as oil recovers without taking on too much risk, and one natural gas stock that even North American natural gas bears would like.
The Leveraged Oil Producer:
Baytex Energy (TSX:BTE)
Baytex Energy shares, which traded for more than $40 in the years leading up to the oil crash, hit a low of just $1.57 earlier this year. While Baytex has a considerable amount of debt ($1.9 billion) relative to the cash flow it can generate at current oil prices, the debt is structured in a manner that provides Baytex a long runway to manage through low oil prices. There are no near-term worries, even if the oil rebound takes longer than expected. The company has plenty of liquidity and no debt maturities of any significance prior to 2021.
Baytex also has some very good oil assets both in Canada and the United States. The U.S. assets are focused on the Eagle Ford shale in Texas and by all indications are in the better part of the play. The Canadian assets are heavy oil assets, which by their nature have higher operating costs and therefore require higher oil prices. Those heavy oil assets don’t work well at current prices but generate a lot of cash flow at $60 or $70 oil. Because of the fixed nature of these operating costs, few companies are going to get a bigger cash flow increase than Baytex when oil moves higher.
The Natural Gas Producer:
Valeura Energy (TSX:VLE)
I’ve been looking for a chance to get bullish on natural gas prices since 2009. With the incredible amount of success that shale gas producers in North America have had, that has been just about impossible to do. Elsewhere in the world though, things are very different. Take Turkey for example. In Turkey, natural gas prices have recently been nearly $10 per mcf, which is five times what producers receive in North America.
But the price of natural gas doesn’t do justice to the pickle that Turkey is in. The country imports 99 percent of the natural gas it consumes. Worse still, Turkey is on very bad terms with the largest supplier of natural gas in the region, Russia. My point is that the country is very motivated to treat its domestic producers exceedingly well.
Little Valeura Energy is a rare bright spot for Turkish natural gas production. The company has 308,317 net acres of land with potential for reserve growth in both conventional and unconventional natural gas. Of particular interest is the potential for a major shale gas play on its Banarli Licence in the Thrace Basin.
The company is debt free, has a proven management team and trades at a miniscule price relative to its cash-generating ability and appraised reserve base. The stock is quite volatile though and my advice would be to wait for a selloff to take advantage of that volatility.
The North American Services Company:
Canadian Energy Services (TSX:CES)
If you have seen a recent rig-count chart for North America you know that this oil crash has been brutal for the service sector. Not only has demand for services dried up but the producers have squeezed the service sector relentlessly for price concessions as well. The share prices of these service companies reflect these facts. As a gradual recovery transpires, one of the service companies that I’d be interested in owning is Canadian Energy Services. What I like about this particular company is that it has built up a business diversified across most of the North American resource plays. Activity levels in these plays are way down, but that is going to get better over time.
I’ve seen repeated statements from companies like Chevron, Marathon Oil and ConocoPhillips that indicate that they will be moving away from multi-year mega projects and towards shale. After being reminded that this is a very volatile business the short-cycle nature of shale production now looks much more appealing than spending billions and years in pre-production on a deepwater or oil sands development.
This trend will be very good for Canadian Energy Services. I’m very comfortable with Canadian Energy Services’ balance sheet which has 1:1 net debt to 2015 EBITDA and nothing drawn on a revolving credit facility. I also like that management owns 15 percent of the shares.
The Oil-Weighted Royalty Company:
Freehold Royalties (TSX:FRU)
The shale boom caused a great surge in both oil and gas production. What it didn’t do is create a surge in free cash flow for producers. Collectively this industry was vastly outspending the cash flows that it generated even at very high oil prices.
That is what attracts me to Freehold Royalties. It actually generates a significant amount of free cash flow while still providing exposure to rising production and commodity prices. Freehold owns mineral rights on land that oil and gas is produced from. The oil and gas producers have to pay Freehold a percentage of the revenue that they generate from production.
While oil and gas producers have to spend huge dollars to drill and frack wells and lay pipelines, Freehold doesn’t have to do anything. The company just sits back and deposits checks into the bank. This is just like the relationship I have with the Government of Canada. I do all the work, and they cash the checks I send them.
Freehold was formed in the mid-90s as a spin-out of a half million acres from the Canadian National Railway pension fund. Over time that acreage position has been built to more than 3 million acres through a steady stream of intelligent acquisitions.
The Insider Buyer:
Surge Energy (TSX:SGY)
Insider buying guarantees nothing but it certainly can’t be a bad sign. At Surge Energy, the amount of insider buying that has taken place in the open market over the past couple of years is head-turning. CEO Paul Colborne has increased his ownership stake through open market purchases by more than 3 million shares over the past four years. There are other things to like about the company, including the fact that it is focused solely on “conventional” oil and gas assets.
Conventional reservoirs are better than shale or tight oil. The conventional reservoirs have lower decline rates (Surge has a corporate decline of 20 percent), which means less drilling (and spending) is required to maintain production.
These reservoirs also respond better to secondary recovery like waterflooding, which is where extremely high returns on every dollar spent can be earned.
Surge has done a good job maintaining its balance sheet having actually reduced debt from $590 million at December 31, 2014 to only $117.4 million currently. The company has a significant amount of room on its balance and pays only $1.19 per barrel of oil produced in interest. Surge is in much better shape to withstand lower oil prices sticking around longer than expected than most of its competitors.
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