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Why it could be time to invest in oil companies again

With oil prices creeping back upward, brave investors are re-examining energy stocks. But be prepared for some volatility along the way

Oil derrick visible against orange sky

(Spencer Platt/Getty)

The time to buy tulip bulbs is when they’re dull blobs, not when the flowers sprout in spring. Investors would be wise to take a page from the gardener’s handbook. As much as we want to buy things when they are most attractive, the best investments are usually the ones covered in dirt.

For the past two years, energy stocks have looked quite dirty, as the price of oil sank to a latter-day low of US$27 a barrel in February. At that price, most Canadian producers can’t cover their operating costs, let alone fund the effort to replace their reserves. But as oil prices firm up around the US$50 mark, investor anxiety is abating. Industry fundamentals are clearly improving: American production is down, consumption is up and supply and demand are inching toward a balance. And since there’s been so little investment in the sector for two years, there’s a high possibility of demand exceeding output in the future. That presents an enticing prospect for companies that maintained or increased production through the crash.

Just be wary of basing your investment decisions purely on the direction of oil prices. Crude may have stabilized, but few see it staying that way. Expect higher highs and lower lows than we grew used to in the years leading up to 2014, says Greg Pardy, an analyst with RBC Capital Markets. You need only look at the growing dysfunction within OPEC, which weakened that organization’s influence over global oil prices, to see evidence of that. “Turbulence is going to be the watchword,” Pardy warns. “Don’t just take a punt on the oil price, because the path of recovery is going to have its ups and downs.”

Investors need a long view on energy and should be prepared for some adversity. “If the oil price is going down, it’s very difficult to stand in front of that speeding train and hope you are in the one or two stocks that aren’t highly correlated with the downward movement,” says Randy Ollenberger, an analyst with BMO Capital Markets. Even US$50 oil isn’t the kind of fertilizer to bring the sector back to full bloom. Investors’ best bet is to pick stocks that will perform at that level and stay solvent amid volatility.

In Canada that means recognizing there is more to the sector than heavy oil. “Not all investors understand there are different types of projects, different types of techniques and different qualities of oil that come out of the oilsands,” says Ollenberger. Pardy expects we’ll see a gradual shift out of integrated oil companies and into riskier, more volatile exploration-and-development and oilfield services stocks that can offer more upside, although he stresses that you can’t lose sight of the companies’ balance sheets.

Targeting low-cost, low-debt producers of any kind is more complicated than it sounds, however. While companies will report their costs per barrel, they may not provide a complete picture. Often these figures leave out important items like debt, transportation tolls and the cost of land. It’s up to investors to try to figure out these full-cycle expenses.

Joe Overdevest, a portfolio manager at Fidelity (Canada) Asset Management and co-manager of Fidelity Global Natural Resources Fund, suggests calculating a company’s netback, which is a snapshot of how much money a producer is paid per barrel (or equivalent), and the recycle ratio. Take the netback, divide it by the operating cost as well as the money needed to buy and develop the land and the well itself. If your netback is $20 a barrel and your costs total $10 a barrel, the recycle ratio is two, meaning that for every dollar you put into the ground, you get $2 out, Overdevest explains.

Stocks that show up well by that measure include oilsands giant Canadian Natural Resources (TSX: CNQ), and Parex Resources (TSX: PXT), a Calgary-based producer operating in Colombia. As the oil sector becomes increasingly focused on margins, Parex benefits from the low costs in that country, without the market access problems that impose a discount on crude prices in Western Canada. According to RBC, Parex’s reserve replacement costs come in at less than US$1 a barrel.

Still, Ollenberger believes investors have to look beyond the operating costs. “That on its own doesn’t tell you a heck of a lot,” he says, which is why he recommends factoring in the annual reserve replacement expenditures and financing costs to see if the company is still generating a margin. “It’s going to be a rough estimate, but it’s better than looking at those variables in isolation,” he says.

The return on capital employed, a ratio that overlays a company’s profitability with how efficiently it puts capital to work, is another important metric to consider. The higher the number, the more efficient the company ultimately is.

It’s also important to remember that the energy sector is a very cash-intensive business. It’s imperative that investors keep an eye on cash flow. They need to get a sense of how much money a company would need to sustain itself if it stopped growing, as many companies have done in recent years, says Overdevest. Even if a business doesn’t have strong cash flow now, try to understand what its potential to generate cash is and pay close attention to how the money is being used. Is it being spent on dividends or reinvested in the company?

Ollenberger agrees. You want to own companies capable of making investments from their cash flow from operations, rather than having to dilute returns by issuing equity or adding debt, he says. Once again, Canadian Natural is a company that excels here. One of the things Pardy likes about the Calgary-based oil and gas company is its upstream growth and potential free cash flow once its Horizon oilsands expansion bears fruit in late 2017. “They are extremely well-positioned to be capturing a lot of cash flow because they have a lot of production coming online,” he says.

Raging River Exploration (TSX: RRX) is another company that looks good on a cash-flow basis. In a wide-ranging note on the sector, RBC says the company has one of the lowest net debt–to–trailing cash flow levels in its coverage group. Seven Generations Energy (TSX: VII) and Peyto Exploration & Development Corp. (TSX: PEY) are intermediate energy companies also growing their cash flow.

With so many beaten-up balance sheets in the Canadian energy sector, investors have to consider a company’s debt level too. “Equity analysts have had to become quasi–debt analysts,” says Pardy.

Still, it can be easy to get caught up in all of these calculations. Perhaps the best advice is to stick to the principles smart investors employ whenever they consider an investment, says Overdevest. “Is it a good business, does it have strong management and how is it valued—because sometimes great companies don’t make great stocks.” Investors should ensure management has a good track record and is running the company prudently. Many executive teams in the oilpatch have run multiple companies in the past, explains Overdevest, which gives an investor a great window into how effective they’ve been.

Given the still subdued state of oil and gas prices, it’s a stock-pickers’ market. The companies that are going to distinguish themselves are the ones that have been able to stay the course, particularly when it comes to adding future capacity.

“If you are investing in energy, you have to believe margins are going to improve,” says Pardy. Just remember, oil and gas stocks have already come off their lows. If you intend to add more energy names to your portfolio, you need to come up with solid reasons that their operational and earnings outlooks will keep improving.