Editor’s Note: Today’s OGIB is my interview with fund manager Chris Theal…
The Big Investing Themes for Kootenay Capital fund manager Chris Theal right now is oil field service companies (OFS), and heavy oil producers.
Driving these two themes are:
1. Liquid Natural Gas (LNG) in North America
2. The huge growth in moving heavy oil by rail
“The reason to be overweight services is that we are seeing a change in the face of the oil field service consumer in Canada,” he told me in a recent phone interview from his Calgary office.
“The customer base is increasingly geared to national oil companies, the super majors—it’s no longer a junior just adding a rig or two when commodity prices go up. And you run down that list and you have Petronas going from five-to-25 rigs in the Montney play. I think, Chevron and Apache are gearing up for a very active 2014 in the Horn River-Liard Basin and Petrochina in the Duvernay.”
We packed a lot into our 40 minute talk. We talked about which sectors he thinks will go up (Oil Field Services and heavy oil producers), where he’s ambivalent (natural gas and yield securities—interest rates are going up) and what he thinks might be a good short soon (US refiners). We also talked about The Big Mistakes retail investors make.
But he was most keen on what the opportunities are for capital gains in the Canadian Oil Fields Services sector due to all the spending to get ready for LNG exports off Canada’s west coast.
“A couple of heavyweights, Chevron and Apache, are looking for specialized rigs to be built and put into the field up in the Liard and Horn River Basins for very LNG oriented type activity.
“That is creating demand for specialized rigs and pumping gear. I say specialized rigs because if you look at the rig count we’re about 100 rigs lower year-over-year and you really have to dissect the data to see the underlying strength in rigs that can drill deep, horizontal wells.
Theal says that year-over-year, well licenses are up close to 70% for the deeper 5,000 meter wells. So it’s important to have exposure to the drillers that have the Tier 1, high horse power rigs that specialize in deep drilling.
“For us that’s stocks like Western Energy Services (WRG-TSX) and Trinidad Drilling (TDG-TSX). But for every Tier 1 rig that goes to work there is a multiplier effect of well completions—and whether it’s outright pressure pumping or coil tubing we think there is a far bigger impact on the pumpers.” (Ed.Note-‘pumpers’ is industry lingo for the hydraulic fracturing companies).
“So we own Canyon (FRC-TSX), we own CalFrac (CFW-TSX) and we own Essential (ESN-TSX) on the coil tubing front. That sub sector has been one of the top performing sectors within the energy space this year. We’ve had really good performance out of it and it remains number one with very good momentum.
“So the fundamentals are there and I think as we come out of June it will be a seasonal period of strength in that space. So far it has been strong and it’s been more the pumpers. I think the Tier 1 drillers are the next that will really see that move.”
Theal’s second Big Theme in 2013 is heavy oil—which has turned around very quickly, due to rail transport. Only six months ago in December 2012 Canadian heavy oil was trading under $50 a barrel on some days, because of pipeline constraints and refinery shutdowns. Now it’s just a few pennies shy of $80/barrel—and Theal says that pricing is here to stay.
“The big change is you have rail impacting the market. Canada’s moving about 80,000 barrels a day of ‘heavy’ right now and we think that will double by the end of the year. And combined with the coker conversion at BP’s Whiting, Indiana refinery we actually think new demand (infrastructure) will outpace any new oil sands supply coming on.
“In the last week we’ve seen a couple of investment houses turn bullish – narrowing heavy oil differential assumptions meaning higher realizations for the producers. I think we’re going to see more of that.
“The bottom line is from a heavy perspective we’re seeing new demand infrastructure related capacity coming outweighing new supply and that’s going to keep differentials narrow and I think momentum on heavy oil prices favours the producers, so that would be the number two long allocation in the fund.”
Theal believes the Canadian oil price has even a bit more upside left, and the stocks of Canadian heavy oil producers should benefit:
“With rail, pay the transport cost to get it to the US Gulf Coast where Mayan heavy is trading at $100 a barrel, so 100 less 20 to get it there you’re seeing the potential for $80 realizations.”
But the Keystone pipeline is still a big issue for Canada, Theal adds.
“I think as much as rail is physically changing market access right now,the international investor sits and looks at Canada and says ‘Well you know what, I see reasonable value there but there is this Keystone debate’. The whole market access issue in Canada has been galvanized around that pipeline.
“I think it’s a very big headline event to the Canadian sector. We think Keystone is going to be approved; it’s just a question of when. When it is I think it is ‘Risk On’ for international investors coming back into Canada. I would say you’ll see senior heavy oil stocks up 10% the day Keystone gets approved.”
Now, by definition, high Canadian heavy oil prices are bad news for US refiners—that’s their input costs. Besides that, the Brent oil price upon which their refined products are sold has stayed flat so Theal is avoiding that sector.
The other sector to avoid energy infrastructure dividend stocks. That sounds counter-intuitive, but Theal says they are going through a correction now and he’s playing that on the short side.
“I think the number one negative theme is with the 10 year yields rising and all the interest sensitive sectors, whether they’re REITs or energy infrastructure—they are really rolling over and rolling over hard.
“As the 10 year yield goes up analysts will start increasing their discount rate. I’d say it’s more a correction than a secular call in that space. And when discount rates go up you kind of let the air out of the tires a little on that sector and that’s what is happening right now. It’s way more pronounced in the US than Canada at this point.
“And I think right now yield sensitive securities generally are seeing out flows.
Theal on natural gas: “We’re pretty balanced on our gas view. I don’t want to say we’re short gas because we’re not, but we’ve a more tempered view of the upside from here in gas and generally our high conviction picks have lots of resource optionality that we don’t have to pay for. And our shorts are exactly the opposite of that; where the market is fully pricing in the upside. We just don’t think the environment is one where we pay for a bunch of undrilled inventory, particularly when so many companies are trying to sell themselves.”
Theal is now on the buy-side, as a fund manager, but also spent 13 years on the sell-side, as an brokerage firm analyst. With that kind of experience, what does he think retail investors could do better in their research, to make money more consistently in the energy markets?
First thing, he says, is find management teams who know how to manage debt; their balance sheet.
“I think if you go back through my length of time, the guys that ran really good companies and were successful through any part of the cycle–they had balance sheet discipline. It was generally the first slide in their presentation.
“They would consistently find a nice deal to do—but they would back stop it with equity and shore up the balance sheet and retain a lot of financial flexibility.
“Now you see guys out there doing deals with debt on the hope that they can show the market an accretive acquisition, get a bump in the stock and then do a subsequent financing. The market, I think, is more efficient when it sees stuff like that particularly in the small cap environment that we’re in.
The other suggestion he gave me is a bit more difficult for retail investors. He says most oil and gas plays are a lot more variable than you might think. Management will say what the “type curve” is for their play—how much oil they produce over what time frame. But investors should understand that’s generally a bullish number.
Then what happens is the sell-side analysts use simple math, extrapolating out that type curve to every well over the entire acreage in the Company’s play, and put a juicy NPV, or Net Present Value on it.
Geology and economics rarely work together that way.
“What you want to see in good work is—what is the variability around that type curve. Then you should assign a higher risk factor and a lower chance of success.”
Of course, investors could put some of their portfolio into the hands of specialist fund managers ;-).
“I think an important thing of being a specialist fund in a sector is (1) getting the commodity call right and (2) getting the sub sector call right. It’s really understanding capital flows within energy and how they move around from sub sector to sub sector. So really moving into services we’ve been there early and that’s worked well and I think we’re just at the front end of the heavy oil thesis.”