Energy Prospectus

"We believe the following to be a critical distinction: as a result of OPEC having increased production over the past 6 months to prepare for Iranian export reductions the oil market has transitioned from one that is dramatically undersupplied with adequate spare capacity to a market that is now more balanced but with little to no spare capacity. Which is more bullish for oil? We continue to believe that a major theme in 2019 will be the exhaustion of OPEC spare capacity. Saudi Arabia, the UAE, Iraq, Russia, and even Libya are now all producing at 3-year highs. Collectively we believe OPEC has at best 1MM Bbl/d of further capacity which in the context of a 100MM Bbl/d market would be the lowest level in recent history. As a result OPEC collectively has very little shock absorption capabilities to any geopolitical event."[/i]

This article on Bloomberg explains the recent pullback in oil prices and why (in the author's opinion) it will be short lived: http://cms1.ninepoint.com/commentary/co ... nd-102018/

Oil Macro Summary

Over the past month the financial demand for oil has fallen to a multi-year low even though physical demand continues to grow strongly and while forward estimates are being revised lower they still exceed 1.4MM Bbl/d and are likely understated due to the IEA’s tracking error. While the issuance of Iranian import waivers to some countries was an expected event the apparent magnitude exceeded expectations and increased the risk that OPEC+Russia’s production increase would not be matched off resulting in a looser market. We believe that increased clarity around trade tariffs and empirical evidence of Iranian reductions will improve sentiment towards oil. We still believe that inventories will continue to fall in 2019 and approach record low levels in 2020 resulting in a price at or near $100/bbl. Given that we are past the midterm elections and that Saudi Arabia may have been caught off guard by the level of waivers issued (in contravention of a backroom deal struck earlier in the year for Saudi Arabia to increase production in exchange for the US coming down hard on their mortal enemy?) there lies the likelihood that OPEC will begin to raise the possibility of production curtailments if the price of oil weakens further. OPEC member countries are all driven by their own self-interest and many (including Saudi Arabia) have significantly higher required oil prices to reverse fiscal deficits / foreign exchange reserve drawdowns.

Eric Nuttall
Partner, Senior Portfolio Manager
Ninepoint Energy Fund / Ninepoint Energy Opportunities Trust

Investment Strategy

We have been very clear in our investment approach this year and have been using the same playbook we used in 2016 that resulted in a 143% appreciation in our Fund’s NAV from February-December 2016. The core of our thesis is to identify opportunities that the market is overlooking due to either laziness, disinterest, or lack of staying power, build a strategic position, and wait for market fundamentals to validate our view resulting in significant appreciation. We had positioned the Fund accordingly believing that 2018 upside could exceed what we experienced in 2016 provided that:

1) Oil appreciated to $70/bbl by YE’18 (this was our forecast back in January when oil was at $60/bbl)
2) Fund flows returned to the sector to allow for stock valuations to get back to a more normalized level (5x-7x EV/CF)

A month ago it finally began to feel that we were on the right path as stocks were beginning to perform, midcaps were beginning to outperform large caps, and generalist investor interest was beginning to finally translate into buying. Then the oil price imploded.

Given the extreme level of sector disinterest and the outperformance of large caps during the past several years we made mid cap/higher beta stocks a major weighting in the Fund believing that buying companies trading at 5%-10% free cash flow yields and 4X-5x EV/CF multiples (vs. a more historical multiple of 7x-8x EV/CF) offered compelling value with the potential of 100% future returns. We were wrong. Over the past several months those same stocks have become 10%-25% free cash flow yields and now trade at 3x-4x EV/CF. We were clearly early. The “no bid” energy market has not received significant enough funds flows yet to allow stock prices to better reflect long term value and the few remaining energy dedicated funds in Canada are not enough to accomplish this on their own. We need generalist money to come back into the sector.

Clearly there is upside in the entire energy sector given the dislocation between oil and oil stocks. The 2019 WTI strip is $63/bbl and stocks are trading off $50-55/bbl oil. Yet, where do we see the biggest opportunities with the highest possibility of a rerate that could see the stocks double to triple? The two areas that we are focused on now are:

1) WCS exposed names (or those perceived as WCS exposed) that have gone “no bid” and are trading as if WCS differentials of $30+ will last forever
2) Permian names that had sold off early in the year due to pipeline takeaway shortages in 2019 yet on 2020 under normalized differentials are trading at 3x-4X EBITDA vs. a historical 6x-7x

So why are we bullish Canadian heavy oil names when everyone else hates them? It is because the multi-year narrative of lack of pipeline capacity and the view that Canada is led by a bunch of environmentalist wingnuts willing to sacrifice $20BN+ per year in lost royalties and taxes in order to placate foreign-backed environmental terrorists has led to mass capital exodus resulting in universal hatred. No one owns Canadian heavy oil names, they are trading at their lowest valuations in my career, and yet if one were to connect just a few dots it would become obvious that the WCS differential will materially tighten in 2019 (and beyond). So why will WCS differentials narrow in 2019?

1) Crude-by-Rail (CBR) is ramping faster that what consensus believes
2) Producers have announced shut-ins amounting to 160,000+ Bbl/d
3) The Sturgeon Refinery will soon become operational and consume 80,000Bbl/d of Canadian heavy oil
4) Pipelines will (eventually) get built – Line 3 (380k bbl/d in Nov’19), Keystone XL clarity in early 2019 (830k bbl/d), and likely clarity on TMX (590k bbl/d) before the Fall’19 Federal election

Crude-by-rail is perhaps the stupidest outcome of the foreign-backed environmentalist movement against Canada/Canadian oilsands production. Rail as a means of transporting oil to the US Gulf Coast is twice as expensive and more importantly significantly more dangerous than a pipeline (ie. Lac-Megantic). However, until Keystone XL and/or Transmountain gets built it is a necessary evil for the industry and a key reason why differentials will fall to $20-25/bbl by mid-2019. Crude-by-rail loadings in Canada were 229,544bbl/d in August up from 120,000bbl/d in August 2017. Given the current market imbalance of 165k-180k bbl/d an increase in crude-by-rail loadings is critical to reach balance. We believe that CBR will ramp to 455,000bbl/d in mid-2019:

CN Rail: “Crude oil shipments next year will probably surpass the 130,000 carload mark set in 2014”

Source: Bloomberg, October 24, 2018

CP: “We’ll move into that sort of 100,000 annual run rate as we get into Q1, get through the Winter, to that ramp-up [to 110,000-120,000 car loads]”

Source: Company Q3 earnings call, October 18, 2018

Combined between CN and CP we expect approximately 250,000 carloads of crude by rail in 2019. Adjusting for the blended mix of crude shipped (CN 80%/20% dilbit/raw bitumen and CP 100% dilbit with 676 barrels per railcar for dilbit and 565 barrels per railcar for raw bitumen) we arrive at our annual forecast of 455,107Bbl/d. This is could be 100,000Bbl/d higher than consensus.

The second component of rebalancing the heavy oil market are shut-ins. This is not the most eloquent solution as these volumes will eventually return to the market but in an environment of $40-$50/bbl WCS differentials are necessary. From Q3 reporting we have tallied the following announced shut-ins:

CNQ 45-50k bbl/d DVN 25k bbl/d BTE 5k bbl/d
CVE <50k bbl/d (30?) MEG 10-15k bbl/d HSE 20k bbl/d
JACOS 20k bbl/d (?) ATH 5k-8k bbl/d TOTAL: 160k-173k bbl/d

With CBR ramping from 330k bbl/d to 455k bbl/d (125k bbl/d increase) by mid-2019 combined with (temporary) shut-ins of roughly 160k bbl/d this equates to 285k bbl/d of incremental tightening versus a 160k-185k bbl/d surplus + 2019 production growth potential of ~100k bbl/d Q4’19/Q4’18. In short, the market could balance by early 2019 and Line 3 coming online in November ’19 (380k bbl/d) could negate the need for all of the announced shut-in volumes. While CBR will still be necessary for the foreseeable future this tightening of the WCS market should allow for differentials to fall to rail economics (~$20/bbl) in 2H’19. This will have a dramatic impact on both heavy oil company cash flows (ATH’s cash flow at $70WTI DOUBLES with a $10 reduction in WCS differentials) as well as sentiment. We own names like ATH and BTE that could easily double to triple from current levels (ATH trades at 3.1x EV/DACF and a 18% FCF yield at $70WTI and a $20 differential with a 76 year reserve life while BTE with 43% of their cash flow coming from the Eagleford play in Texas which gets a $5/bbl premium to WTI trades at 2.8x EV/DACF and a 26% free cash flow yield under the same commodity/differential assumptions).

The other major theme that we have exposure to is the Permian Basin, the epicenter of US production growth. Permian names were weak earlier this year due to a temporary shortage of pipeline capacity as a result of midstream companies having underestimated the degree of success that Permian producers would have in growing production. We see this bottleneck ending by the end of 2019 and this will unencumber many who are being partially impacted in 2019. Many of our holdings have well over a decade of high quality inventory and at $70WTI can grow production by 20%+ while spending less than 1x their annual cashflow. Much of the early shale boom was spent on acreage accumulation and appraisal drilling. Now, industry is transitioning into development mode where return of capital can be prioritized allowing for an attractive combination of production growth and buybacks/dividends. Permian names are trading at an average 2020 EV/EBTIDA of 3.4x, P/E of 6.2X, FCF yields of 10%+, and are expected to have ROCE of 16% at $70WTI. Typically oil names trade at an infinite P/E given they never have earnings and a EV/EBITDA average of 6x-7x. As more infrastructure is built allowing for increased exports we also believe Permian producers will get product pricing more akin to Brent than WTI and this 2020 upside has not yet been discounted into share prices. We see 80%-130% upside in our Permian names.

In the commodity sector bottoms are typically found when:

1) Stocks positively diverge from the commodity – we have in recent days see energy stocks up 2%-3% when oil was down by 2% on the day
2) M&A picks up – we have seen a flurry of deal activity, both friendly (ECR, PVAC, WRD, NFX) and hostile (MEG, TDG)
3) Companies start to buy back their own shares – SU increased their buyback from ~$2BN to $3BN, CNQ formalized that 50% of free cash flow in 2019 will go towards share buybacks, some large US companies have bought back 10%-20% of their shares outstanding this year

We cannot speak to when generalist money comes back into the energy sector because we are at a loss as to why we haven’t seen it already. Before the selloff stocks were trading at 10% FCF yields and EV/CF multiples HALF of their historical averages. Today we can buy names like Baytex where the stock has fallen by more than half over the past 5 months, trades at a 24% free cash flow yield and 3.2x EV/CF multiple and offer us 150% upside at a 5x multiple and $70WTI / $20 WCS differential. Such opportunities should not exist yet here we are. If generalists continue to shun the sector, given how strong the free cash flow yields are in 2019 I would expect more companies to adopt aggressive share buyback programs. That is something we are encouraging all of our holdings to do. We would also expect to see more M&A such as MEG Energy, a former holding which was opportunistically put into play by Husky due to the market’s current distaste for Canadian heavy oil names and myopic inability to look through the very near term resulting in an asset changing hands at the worst part of the cycle (for MEG shareholders at least).

Dan, you stated your source was Bloomberg, but everything quoted is from Eric Nutall's newsletter. I could not find anything on Bloomberg quoting this.

I think Bloomberg ran the article, but they are Eric's comments.