Oil and gas: energy drain

Take a quick look at the Canadian companies that generated the best returns during the past year. You'll find many of the big names that powered the great energy boom through the first part of this decade at the wrong end. Suncor Energy Inc. (TSX: SU), Penn West Energy Trust (TSX: PWT.UN) and even mighty Canadian Natural Resources Ltd. (TSX: CNQ) are all down. 1.8%, 9.2% and 0.7%, respectively. So, too, are many smaller Canadian oil and gas companies such as Peyto Energy Trust (TSX: PEY.UN), Calfrac Well Services Ltd. (TSX: CFW) and Highpine Oil & Gas Ltd. (TSX: HPX), which all dropped more than 30%. Overall, the TSX energy index went sideways while the composite index climbed about 11%. What happened to the great energy bull market of the 21st century?

But the present downturn should probably only last for a few more months, and is merely a blip in a bullish longer-term outlook. Or so say analysts. “I would call this a correction in a larger upward trend,” says George Gosbee, CEO of Tristone Capital Inc., an energy-focused investment bank located in Calgary. His sentiment is widely shared. “We're still in a secular, long-term market,” says Ari Levy, a Toronto-based energy fund manager with TD Asset Management Inc. “That doesn't mean there isn't shorter-term cyclicality.”

Indeed, anyone investing in oil and gas would be wise to pay attention to long-term economic fundamentals. particularly slowing oil and gas discoveries versus rising global demand. and not get caught up in short-term price fluctuations, says Fred Sturm, the Toronto-based chief investment strategist of Mackenzie Financial Corp. “Our basket of energy prices fell 60% from highs in January 2006, so we've had a good shakeout,” says Sturm. “But we have quietly found a new cycle.” He points out that the average North American uses 25 barrels of oil a year, while the average consumption in China is just two barrels per person. With millions of Chinese rushing toward the middle class, there is clearly a lot of demand yet to come. “The fundamentals for energy are still excellent,” says Sturm.

Yet not every company will rebound. Playing natural gas companies can be particularly tricky. There's more natural gas in storage than ever before, meaning prices aren't likely to move up soon. “There's lots of gas in storage right now,” says Levy. “But that can be drained by a hot summer. And it's much more difficult to replace reserves than it was 10 years ago.” Production in the Western Canadian Sedimentary Basin peaked in 2002, and drilling activity is expected to drop 15% to 20% year over year, so the key is finding those companies that can continue to produce. Tristone's chief of research, Chris Theal, believes ProEx Energy Ltd. (TSX: PXE), NuVista Energy Ltd. (TSX: NVA) and Cyries Energy Inc. (TSX: CYS) are companies that will do well in this environment. Levy also points to oil and gas services provider Trican Well Service Ltd. (TSX: TCW). “It has broken out of the oilpatch and has some work in Russia. That's going to be gravy for them.”

Outside of the TSX, Sturm likes big global offshore drillers such as Diamond Offshore Drilling Inc. (NYSE: DO), Noble Corp. (NYSE: NE) and Schlumberger Ltd. (NYSE: SLB). “We're more excited about the eastern hemisphere. We're not in the . it's gone' camp,” says Sturm. “We're in the . easy stuff is gone' camp.” One of Tristone's other picks is Devon Energy Corp. (NYSE: DVN), which hit oil 8.6 kilometres under the Gulf of Mexico with its super-deepwater well, Jack. Getting the oil out will be expensive, leading some to suggest the cost of drilling that deep doesn't leave much room for profit. Nevertheless, the ability to tap heretofore-untouchable reserves has generated interest in the company.

Further afield, junior producers are getting a taste of the North Sea. The U.K. government rejigged the regulations around drilling in that basin, forcing the majors toinvest in their assets there or get out of the way and let smaller companies do it. Drilling in the North Sea is not as profitable for companies such as Exxon Mobil Corp. (NYSE: XOM) as it once was, so it makes sense to hand over the platforms to smaller companies that don't have the big overhead and can scrape out a profit. “It's like Canada in the '80s,” says Theal. “The assets are moving into the hands of juniors, and the big companies are moving out.” Two companies Tristone expects to profit from that trend are Ithaca Energy Inc. (TSXV: IAE)and Bow Valley Energy Ltd. (TSX: BVX).

For larger integrated oil and gas plays, Levy likes Chevron Corp. (NYSE: CVX), which has finally digested the assets of the old Texaco Corp. “A year ago, we recognized they were on the cusp of turning around,” says Levy. “We also like the large footprint the company has downstream in Asia.” Downstream assets refer to a company's refining and marketing capacity. Having those operations inside a company has proven beneficial of late, and has helped Petro-Canada (TSX: PCA) and Husky Energy (TSX: HSE), says Levy. Husky is trading above its 52-week high, and Petro-Canada, which recently made a concerted effort to streamline its refining capacity, just posted record profits. “These are good times at the operating level. There is little excess refining capacity,” says Levy. And it should remain tight. Valero Energy Corp. (NYSE: VLO), a large U.S. refiner, has just announced it will buy back shares rather than expand its refining capacity.

No story on oil and gas stocks would be complete without touching on income trusts. Trusts were once an easy way for junior drillers to exit developed, mature assets and go looking for more oil and gas. Now that the door has closed on that strategy, some junior drillers will likely experience tougher times, especially considering the rising costs of doing business in Alberta. “Unless they have some kind of special defining characteristic, juniors are going to have difficulty competing for capital,” says Levy. Progress Energy Trust (TSX: PGX.UN), BonaVista Energy Trust Ltd. (TSX: BNP.UN) and Penn West Energy Trust are some of the trusts he thinks can buck the trend. “Penn West seemed to get caught in the downdraft that hit energy stocks, but its underlying asset base has potential to bring material amounts online,” says Levy.

But while the door on trusts is closing in Canada, it appears to be opening in the U.S., where there is increasing interest around master limited partnerships (MLPs), the American version of the income trust. For example, U.S. driller Range Resources Corp. (NYSE: RRC) recently opened 9% higher on rumours that it would convert to an MLP. Similar bumps are sure to follow, and one of Tristone's picks is Pioneer Natural Resources Co. (NYSE: PXD). It's still early days yet, but institutional investors are playing in the MLP market already. “Everyone is in on it,” says Gosbee.