The Q1 Gas Pump Happy Dance with Eric Nuttall

April 2022

Earnings season is underway in the oil patch. Ninepoint’s Eric Nuttall tells @hainsworthtv the Q1 results show that the multi-year bull market continues, and energy companies are rewarding investors in the space.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

Michael Hainsworth:
We’re in the thick of Q1 earnings season, and spring is in the air. Crude oil is headed to its longest run of monthly gains in 4 years, pushing prices to the highest level in 14 years. The front month of WTI has managed to maintain its position well above the 200 day moving average and has retested its 50 day moving average more than a few times in the past few weeks. So I asked Eric Nuttall, the man running the world’s most successful energy fund, if the 52 week high of $123 a barrel is the new ceiling. And what does it mean for earnings and the summer driving season? He just laughed.

Eric Nuttall:
It's so tough to triangulate short term moves because we have to deal with so many cross currents and noise in the market. We've had to deal with regional lockdowns in China, we've had the Biden administration try to first talk down and then try to move down the oil price, given the SPR releases. I reflect back on we are in a structural bull market due to structural supply challenges and we are an environment, then, of higher oil prices, which I think we're finding a very good $100 floor.

Ultimately, I think oil has to go high to kill discretionary demand. I thought that was going to be a summer of 2022 event but given the usage of SPR releases by the greatest extent in history, I think it's pushed out that inevitability to 2023 at some point, but really, it's kind of moot, frankly. When I look at what energy stocks are trading at now, trading at 30% free cashflow yields, we can buy names literally using $100 oil now trading at one and a half times cash flow. Whether oil's at 100 or 120 to me is really irrelevant given the complete breakdown between what I think energy stocks should be trading at and where they're trading at today.

Michael Hainsworth:
On the topic of demand destruction though, what about a one, two punch? Not only the high price of crude oil and ultimately the prices at the gas pumps, but overall high inflation and low economic growth in the United States. Are you not concerned about that?

Eric Nuttall:
I think we've got such a huge margin of safety given how undersupplied the market is. We were measuring it at about 1 1/2 to 2 million barrels per day pre-SPR release. We didn't account for any drop-off in Russian production and exports, which we need to address. I'm sure we'll talk about later on. Periods of negative demand growth are very, very rare. You'd have to go back to the financial crisis and obviously COVID for those very unique times in history, so I do expect the rate of growth to decline and in fact, that's part of my thesis, but I don't see negative demand growth for the foreseeable future. The trends of declining inventories, we just had the USD re-release US inventories on Wednesday. We track global inventories. The trend remains in our favor, that is fallen global oil inventories, which put meaningful upwards pricing pressure on the oil price.

Michael Hainsworth:
Last month, you predicted OPEC would exhaust spare capacity by September. How has that replacement of Russian exports been coming along and the pulling out of the SBR?

Eric Nuttall:
We're still on track for that for the month of March. We're going to get April data pretty soon, but for the month of March, 7 of the 10 biggest OPEC members were underproducing their quota. I asked the question, "Why would seven countries forsake hundreds of billions of dollars of lost revenue, every single month?" The only reason for that is that they can't. They cannot produce because there's been insufficient investment for too long, and they will have to increase spending, but then we have to deal with cycle time. We're looking at four to six years before these countries can add meaningful capacity and that's true of the global super majors as well, and so far with Q1 reporting, I haven't seen any meaningful increase in spending beyond accounting for inflation.

Michael Hainsworth:
Chevron's posting its highest quarterly earnings in almost a decade. France's Total, better than expected profits. Big oil is really expected to see its best profit since 2011.

Eric Nuttall:
Yeah. It's funny talking to CEOs. We just met with one of the Canada's largest oil sand producers yesterday afternoon and they're giddy because the amount of free cash flow that they're generating is literally unheard of. It's such a unique time in history because when we talk to the largest companies, trading at 30% free cash yields and they're telling us that we're going to get all of it in six months time, beginning early next year. We're getting half of it now and it's going to a hundred percent, so the wall of cash is here.

This is a sector that is going to be debt free next year, so if we're right on oil, which I think we're at a $100 oil floor and going higher, the amount of free cashflow and therefore the dividends and the buybacks that the sector is generating and going to be using, and the re-rate potential that will result from that, I truly don't understand why more people do not see what we see. It is so blatantly obvious to me that companies cannot stay at 30% free cash flow yields when they're giving it all back to investors. I'm so excited about the coming months and quarters and frankly years for energy investing.

Michael Hainsworth:
Which would you rather see, more share buybacks or dividend increases?

Eric Nuttall:
What we're telling our companies, and we run the biggest energy funding in Canada and therefore we're one of the largest energy investors so we have a say at the table. A very friendly say, we're not doing what Elliot's doing at Suncor, but we'd like to be involved in the conversation because we own a lot of company stock. What we're telling companies is, given how profound the breakdown in valuations is today when companies are trading at, on average, 2.2 times cash flow when they used to trade at 7-8, to begin with, let's do buybacks.

We can use buybacks to drive the re-rating and share price and valuations closer to what I think is reasonable, which is about a 4-6 times. That triangulates to about a 12-15% free cash yield. If you can buy a business with 30 years of inventory, therefore 30 years of free cash flow, and they could pay you a 12 or 14% sustainable dividend, that seems like a reasonable place to start in terms of what's reasonable valuation, so step one is drive your share price. Re-rate it through meaningful share buybacks. Get closer to what reasonable fair value is and then start to shift money out of buybacks into variable dividends.

Michael Hainsworth:
You mentioned Elliot, this activist investor's pushing Suncor energy to overhaul management over operational challenges and safety issues. What do you say to an investor holding Suncor stock?

Eric Nuttall:
For income purposes, we own it in our income fund. We do not own it in our primary growth fund for all of those reasons. It is profoundly lagged and there are other companies that we think are much better run and traded, frankly, cheaper valuations, where they've committed to return 100% of the free cash flow back to investors. We think, if you're looking for capital appreciation, there are better opportunities available, less risk and more reward. But I do think something that's being lost is what's the real takeaway from Elliot coming to Canada and approaching Suncor from an activist bend? It's not just a Suncor issue.

I think what it does, it shines a giant spotlight on how profoundly mispriced Canadian energy stocks are when you can literally get decades worth of inventory, therefore free cash flow, therefore dividends for free because of energy ignorance, this mistaken belief that we're all going to be driving electric cars in the next three years, oil's a sunset industry, therefore why would I place any value on barrels to be produced 5, 6, 7, 8 years from now because we're not going to be using this stuff? To me, that is what is creating still a generational opportunity in energy stocks, despite very strong performance year to date and last year.

Michael Hainsworth:
If this isn't just a Suncor issue with Elliot crossing the border into Canada to be an activist investor in the space, what does that tell you for about other Canadian energy stocks?

Eric Nuttall:
I think this could be a turning point and it could be a wake up call to other generalist investors all around the world in terms of how profoundly mispriced energy stocks are. I can tell you we're having conversations with US endowment funds that are looking to Canada, looking to oil sands. I hear stories of European ESG funds saying, "Maybe oil is ESG friendly because we need to displace Russian crude and therefore, maybe we can fit this into our framework." It is that performance anxiety because they're getting slaughtered by not having exposure to the best performing sector on the planet, perhaps. My thesis has always been you would see a return of all of that capital that [fleed 00:09:36]. It will all come back, and whether people get dragged back kicking and screaming or not, performance anxiety on the part of fund managers will force people to come back. A sector trading at 30% sustainable free cash flow yields cannot be ignored.

Michael Hainsworth:
I can imagine crude oil as an ESG play to counter what's going on in Russia would be somewhat of a short-term solution.

Eric Nuttall:
It's a long term problem. When we look at Russia, you've got the second largest oil supporter in the world who is weaponizing its oil revenue to buy cruise missiles, to kill innocent kids, and rape women and run them over with tanks. The developed world has decided that they must get off Russian hydrocarbons. The magnitude of that problem, both for natural gas and for oil, is massive, so this is a long term challenge that global oil producers must rise to.

The challenge, though, is, given how profoundly mispriced their stocks are, you have energy investors like myself saying, "First, we need to deal with the profoundness pricing," so you can't justify growth. It's this weird tension between there's a call on Canadian oil, there's a call on US oil, but there's a gating factor from investors who are saying, "We've just lived through the worst bear market in history, it was miserable. It is now our time to get paid, and we're going to get paid with dividends and buybacks until a time comes when stock prices re-rate and you can justify both growth and meaningful dividends."

Michael Hainsworth:
Let's go back to Suncor for a moment and Elliot. With gasoline prices at record highs, what do you make of the call to sell the gas station business? That sounds like burning the furniture to heat the home.

Eric Nuttall:
I don't want to get too specific in terms of assets within Suncor. My suggestion would be they've probably looked at it in the past and if fair value could be found, every banker in the world probably would've been trying to pitch it. Has there been lack of sufficient health and safety? Probably. I think the number of fatalities that they've had relative to their peers would strongly suggest that. The challenge, though, is a lot of their assets are old, they break down. They need a lot of TLC relative to newer operations, so going out and firing the CEO, it doesn't fix things, necessarily. I think it's going to be a longer term challenge to improve operations there.

Michael Hainsworth:
Let's talk about Sunnova. It's holding back on spending. It says it's religious on how it allocates capital. I suppose tripling the dividend must make you happy here?

Eric Nuttall:
Yeah, we met with Alex Pourbaix and John, their CFO, yesterday afternoon and I've got to say, I've never met a CEO who is more in tune with what investors want and is actively delivering on that. For a business, I referenced Sunnova and it's a fund holding of ours, they're trading at a 29% free cash flow yield at $100 oil, and they've just told you that they're going to give you all of that once they hit 4 billion of net debt, which we have that occurring by the end of this year to early 2023. It goes back to...

I've said the generalist investor, up until recently, has been in this catatonic state of apathy where they just haven't seen what's right before their eyes, which is the generational opportunity in energy stocks, and I always thought it would be the meaningful action on the part of the companies by returning free cash flow back to investors that would shake that generalist investor from that coma, so it's extremely gratifying to see that stock up 16% in the past two days exactly on what we thought would happen. That is the sector is gushing with free cash, and we don't think that's something that's going to be changing. Your sector that your long inventory, your debt free on average next year, what do you do with that cash? There's only one thing to do and it's give it all back to shareholders.

They've set the bar high. Our ask was 75% of free cash flow once companies achieved net debt status. They're going with 100, so I think that puts a lot more pressure on their peers, which really aids us in our mission because we've by far been the spokesperson in terms of the necessity to moderate growth, maximize free cash flow, return it to investors, drive the re-rating and share price, so it's awesome to see someone who's been the best spokesperson for the industry and the CEO of Sunnova now on capital allocation and return of capital really carrying the baton for everybody.

Michael Hainsworth:
What do the reserves look like over at Sunnova? Because if they say they're religious about allocating capital and that their criteria for new spending is $45 oil, why not make hay while the sun shines?

Eric Nuttall:
Again, it goes back to you've got a stock trading at 2.4 times cashflow and a 29% free cash flow yield. What's the best use of incremental dollars? Is it to go grow oil production and you're looking at brown field expansions where it's going to take you a year to three years to add capacity, or is it going out today and buying your stock back today? They have 29 years of 2P reserves and your long inventory, so let's do the math.

I just said they're trending at 2 1/2 times cash flow so round that up to 3. 29 years of reserves minus 3 years, what we're paying for, you're getting 26 years of 29% free cash flow yields for free, and they just told you you were going to be getting all of it. Theoretically, they could pay us a 29% dividend and you're getting 26 years of that for free because people are clueless and they all think that we're going to be not using oil the next couple years as we're all driving Teslas. It's energy ignorance. It's such an important theme and it's such an important thing to keep going back to because that is what is allowing us still to buy companies at a fraction of what we think fair value is.

Michael Hainsworth:
Would you buy Tesla?

Eric Nuttall:
No.

Michael Hainsworth:
No?

Eric Nuttall:
I have no interest.

Michael Hainsworth:
They look like fabulous cars.

Eric Nuttall:
I have no interest. I have anxiety when my cell phone battery dips down, I don't want to be suffering from range anxiety.

Michael Hainsworth:
Big oil is expected to see its best profits since 2011, but I suppose the big difference between now and 2011 is that the industry's investing only half as much into new projects. Where does that leave the global supply?

Eric Nuttall:
Again, it fuels what we have said is a structural bear market due to structural supply challenges. We're in a world where companies cannot sufficiently invest for a variety of reasons. Not just because of investors like myself saying, "Look, your stocks trading so cheaply you can't justify spending money on growth. Go do buybacks, divisions, et cetera." You look to the US, there's profound labor shortages. There's even steel shortages where steel sold out for the next 6-9 months. You need casing for when you drill a well. You've got to put steel into the ground or otherwise the hole literally caves in on itself. Well, steel is sold out, and that's being fueled, again, by Ukraine, a rebounding economy, et cetera.

You've got ESG investing, the divestment initiatives, et cetera, saying, "You need to invest in renewables, you've got to pledge to net zero by 2050." There's all of these forces that are pressuring supply growth in a world where, accounting for the headwinds a little bit in China right now for COVID lockdowns, we were back to pre-COVID levels and that was without the travel surge, which, you talk to the Carnivals of the world, the Uniteds of the world, record bookings. Not just record this year, record in their history, so as we all want to travel, just try booking a hotel room. Try booking Disney for Christmas time. People are going to travel aggressively because we've all been under house arrest for too long and we're yearning to live again.

In a world where demand is going to surge later this year, in a world where I think demand is going to grow for at least the next 12 years, I think much longer than that, what is exciting for an energy investor is there are profound structural challenges on supply growth. The reason why I say it's a multi-year bull market is that cycle time. That's the time it takes to bring on a large project, so oil has to go high enough to both kill discretionary demand and incentivize the most woke of world companies to pivot and start investing again, and even when they do, we're not there yet today, you've got five to six years because that's cycle time to bring on these big projects which the world desperately needs. That's why I think we're on a multiyear bull market for oil.

Michael Hainsworth:
As the manager of the world's top oil fund, how are you managing today? Do you have it on autopilot? We're all supposed to be keeping an eye on our investments and making minute adjustments to accommodate for new information coming in. What kind of adjustments are you making, or are you just sitting there in the office with your feet up?

Eric Nuttall:
No, I've never been more driven to make as much money for my clients as I am today, because it's such a opportunity rich environment because it's inefficient. We're all told in school, "The market's efficient," market efficiency theory and whatnot and everything's properly priced. That's garbage. It's been a game of survivor for energy fund managers. I was an endangered species, so there's not many of us left. What that means is there's not many people that have the ability, the skillset, whatnot, to look for opportunities and to be able to analyze them.

I can buy companies drilling wells that are literally paying back in weeks, so whatever you spend on the well, the cost you get back in weeks. It used to be years, now it's weeks. I can pay the same valuation for that company than for companies with debt challenges or bad management teams or inventory problems or tier two, tier three inventory, so there's so much opportunity now that we can take advantage of and we are taking advantage of. It's the reason why we've done what we've done and we're doing are doing, so no, I'm not resting on my behind. We're looking at research far and wide for the best opportunities that we can find.

Michael Hainsworth:
Is it a buy on weakness scenario? Do you expect a pause that refreshes?

Eric Nuttall:
I can be accused of being a permabull, but I change when facts change, and when I look at an environment where I think a $100 floor is pretty justifiable and I think oil's going meaningfully higher than here, when I can buy stocks... I think the average company in my fund is discounting an oil price less than 60, and we're trading barrels at 105 bucks today, so when I can look at companies, the margin of safety in a sector that is debt free next year and is pledging to return at least half of their free cashflow back to investors, which is a 15% dividend yield, 15% buyback, or combination thereof. Not to say every dip is a buying opportunity, because that sounds overly promotional, but I remain extremely excited about the upside that I see. We have price targets for almost every company in North America ranging between $70 and $120.

What excites me is we can do our own work, we can find the best opportunities where we see meaningful upside from here relative to the risk that we're we're taking on and I don't understand how you can't be excited by that. I go back to I don't understand why more people don't see what we see because it's arithmetic and it's logic, and I think what you're seeing in recent days is perhaps it's the beginning of the Elliots of the world, very, very sophisticated money managers, where are they deciding to come? They're coming to Canada and they're coming to energy, so maybe it's the beginning of others seeing what we see leading to a meaningful re-rating in energy stock valuations.

Michael Hainsworth:
All right. Here's your cocktail party question. Since apparently COVID's over and we can all get back together again, is $1.77/liter the new normal for gas?

Eric Nuttall:
If it pains you to fill up your car it only means one thing. You don't own enough energy stocks or you don't own enough of an energy fund. I do the happy dance every time I fill up because I know that I'm being commensurately rewarded on the other side. I think oil's going up, crack spreads are firm, fuel demands high, so unfortunately, I don't think we're looking at lower, I think we're looking at higher in the coming quarters and years.

Michael Hainsworth:
Eric, thank you, I think.

Eric Nuttall:
My pleasure, Michael. Good to be with you.

 

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

 

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