It is rather remarkable how resilient Western Canadians have been despite the collapse in oil and natural gas prices. Perhaps it’s since the forward marketplace is in contango or just that the broader United states equity markets keeps testing new highs.
That said, optimism tends to turn into a prayer when your patience expires and investors, nine months into oil’s correction, are finally beginning to wonder about the outlook for oil and gas stocks.
Company executives were the first one to hit the panic button, as is evident by a few of the recent bought deal equity financings which were done to reduce debt levels even just in an era of ultra-low interest rates.
In the end, we are able to see why they are concerned.
North American oil and natural gas production is defiantly growing despite a sizable drop in the rig count and collapsing prices. Globally, demand growth has yet to reply to the fire sale pricing and also the Organization of the Petroleum Exporting Countries is holding steady using its let-the-market-decide approach.
Overall, it’s rather troubling that a supply/demand imbalance as little as one million barrels per day (a paltry 1.1% of global demand) can slice oil prices in two and stay there for months at a time with limited reaction around the demand side.
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On the natural gas side, production is constantly on the set new highs despite the fact that there has been a reduction of more than 75% in the rig count. Thankfully, a cold winter out east helped keep demand up, otherwise the would be within an even worse position fundamentally.
The outlook is overwhelmingly still negative, but it\’s important to remember the sector does cycle and we\’re now six years right into a bear commodity cycle that\’s getting a little long in the tooth.
But timing sector tops and bottoms is extremely difficult, otherwise impossible, even if most energy fund managers indicate otherwise.
As history has shown, the sector at times can be very rewarding, but equally punishing for those who give into human behaviour such as: having an excessive weighting to the sector because it is what they know; compounding losses due to loss aversion; attempting to call bottoms and catching a falling knife instead; and herd buying in the tops because of return chasing.
Fortunately, there are some ways to manage the potential risks in the sector while positioning for its eventual recovery.
One of the best ways is to let the management teams of oil and gas companies do it for you.
For example, we like companies that own their very own infrastructure and are therefore able to better control operating costs. As being a low-cost producer in the current environment is unquestionably showing its merits.
Another factor we glance for is a management team not afraid to hedge some production. There is enough risk within the sector related to drilling and completion, land expansion, infrastructure, capital, etc., so why take on excessive commodity risk as well?
Just because the sector is a price taker does not mean companies have to be. Adding a bit of security by hedging forward production can offer a lot more forward certainty.
In the finish, it may mean lacking to sell a crown jewel asset in a depressed market or diluting shareholders by raising equity when their stock price is testing new lows.
Finally, it\’s up to management to help keep a very close eye on their balance sheets and debt at manageable levels. Leverage and drilling can be a disastrous combination – just look at the share prices of these companies with heavy debt loads.
We don\’t know how much longer this bear market will last, but we do know that owning such companies offers an excellent risk-managed approach for investing in the sector and positioning for the impressive gains if this eventually recovers.
Martin Pelletier, CFA, is really a portfolio manager at Calgary-based TriVest Wealth Counsel Ltd. twitter.com/TriVestWealth
