Why stocks are cheap at $100 oil with Eric Nuttall

February 2022

The manager with the world’s #1 energy fund in 2021 says that even at $100/bbl Canadian energy stocks are cheap. Eric Nuttall explains why there are several reasons to remain bullish through 2022.

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

 

Michael Hainsworth:
All right, Eric. Can I get mic check, please?

Eric Nuttall:
Eric Nuttall, partner, senior portfolio manager, Ninepoint Partners.

Michael Hainsworth:
Hey, didn't I read somewhere that you had the number one energy fund in the world according to Morningstar? Congrats!

Eric Nuttall:
(laughs) Thanks very much!

Michael Hainsworth:
So are they going to have to widen your office door to fit your giant head through it now?

Eric Nuttall:
(laughs) I'm pretty humbled.

Michael Hainsworth:
(laughs) All right. Stand by. Here we go!

Announcer:
This is the Alt Thinking Podcast by Ninepoint Partners.

Eric Nuttall:
If you look at the opportunity set today, the average Canadian company is discounting an oil price of about $60. We're trading barrels today at 92, and I think we're going to see a hundred dollars by the end of this year and we'll trade above a hundred, I think, for the next several years. And so I'm still incredibly excited about the opportunity set. When I look at the dispersion in valuations, it's a very tight band, meaning junk is trading at the same valuation level, generally speaking, as quality.

Announcer:
The Alt Thinking Podcast from Ninepoint Partners begins now. Here is Michael Hainsworth.

Michael Hainsworth:
All right. So you know I follow you on Twitter, right?

Eric Nuttall:
I thought so.

Michael Hainsworth:
So I'm very familiar with this one tweet you put out recently that you found from somewhere, titled "Nutty Bingo". So, if at any point with these various tiles here, if you state these particular phrases in a row of three, I just might shout out in the middle of our conversation, "Bingo!"

Eric Nuttall:
Duly warned.

Michael Hainsworth:
All right. So you beat the index by 100% last year. Before we get into how you expect energy to perform in 2022, let's revisit the thesis that got you to where you are today.

Eric Nuttall:
Yeah. So beginning last year, we were fairly confident that we would see an increase in oil price. I think we were at $53 beginning 2021. We thought we would see 60 by the summertime, end the year at 70. And that was pretty bullish. And even we proved to be too bearish. And so we positioned the fund in a basket of Canadian small and mid-cap stocks, where we could see that there would be an exponential increase in their free cash flow with a moderate increase in oil price. And at the time the energy sector was not as in vogue as it is today. And so nobody else wanted to own these stocks.

So we could go and approach... We approach Equinor, formerly called Statoil, and bought a big stake of a company off of them. That did okay. That went up by over 600%, honest. We found companies where we thought, okay, if there's a modest increase in oil price, maybe they'd be able to pay a very attractive dividend or there'd be line of side to de-leveraging to bring them within a more palatable leverage situation, where you could get a re-rating the share price multiple. So it was a very, very target-rich environment then and it remains so today. We see generalists coming back, but it remains such an underowned sector.

And at the same time, when I look at valuations I just blink and I look at my models and I just don't understand why more people do not see what we see, because it's just arithmetic and logic. And it's a challenge sometimes when you're so deep in the weeds that you just have to remind yourself that it takes time. You just have to be patient and just to wait for people to come and see what you see.

Michael Hainsworth:
So because you believe that demand would normalize and supply would remain constrained, you went long on Canadian, small to mid-cap stocks, you say, believing that you were buying value. If that was the case a year ago, are they still cheap?

Eric Nuttall:
It's a fair question to ask, because our fund did 186, 187% last year. This year we're up, I don't know, 26, 27%, whatever it is. And you would naturally think, "Well, my God. The trade is over. These stocks are mispriced," or fully priced, I should say. When I look at one recent example where March of 2000, I bought a million shares of a stock and I believe I paid 29 cents for it. Last week I bought a million shares of that same company and I paid $9 and 10 cents for it. And the value that I paid for it this time was less. It was cheaper than what it was in March of 2020. Okay. How is that possible? And when you look at the amount of free cash flow at an oil price remotely close to where we trade now, I thought I was paying about one and a half times cash flow for this business today where I get measured upside of potentially 200% over the next year or so.

And so yes, stocks have had a good move. I remind myself that so much of last year's performance was a healing process from the bludgeoning that occurred in early 2020, where many stocks fell 60, 70, 80, 90% in the matter of a month or two. And so with a fresh set of eyes where you're not burdened with strong historical performance, where you're maybe more worried about losing it as opposed to making money as a fresh set of eyes. If you look at the opportunity set today, the average Canadian company is discounting an oil price of about $60. We're trading barrels today at 92. And I think we're going to see a hundred dollars by the end of this year and we'll trade above a hundred, I think, for the next several years. And so I'm still incredibly excited about the opportunity set, especially that the Canadian market is so inefficient because there's no one left.

When you think about active managers, it's effectively myself and one other team. And so when I look at the dispersion in valuations, it's a very tight band, meaning junk is trading at the same valuation level, generally speaking, as quality. And that shouldn't be the case, right? Not when you look at companies' inventory depth, balance sheet strength, management quality, all of those attributes that we look for. They're not all constant, but because there aren't enough active stock pickers involved, there's nobody to help create wider variances. And so what excites me, especially this year, is I still think it's a target-rich environment. We can be high quality trading at the same level as junk and be patient and just wait, just wait for generalist money to come, because it is coming. And I can see that coming in real time and we will ultimately get a re-rating in share price valuations from what remains near historical lows.

Michael Hainsworth:
You're not the only one calling for $100 crude. Morgan Stanley's on the same page as you on this. What does demand look like though, considering jet fuel is 10% of the market and most of us still aren't flying?

Eric Nuttall:
So you're raising a very important point, and that is here we sit in February, seasonally the weakest period of the year for demand. And we're back to pre-COVID levels. And you raise the point, to leisure travel, taking your family somewhere is still a pain in the... You know it with all the testing requirements and quarantines, et cetera. What we're seeing in real time, and our federal chief medical officer just said, "It echoes what we're seeing in governments all around the world. Measures need to be relaxed. We need to move from the pandemic to an endemic and people just have to wrap their head around that we're dealing with this." And I think most people are there already.

What that means is that you'll see restrictions continue to ease. And that demand, that yearning to travel, to get out of your house from the two years of house arrest, I think is really going to surprise people to the upside in terms of the demand for leisure travel. And so if we're already back to pre-COVID levels, if we're already at $92 in February, when you get a seasonal uptick combined with that inflection in leisure travel, I think that demand recovery is going to surprise to the upside and that will happen to correspond close to the time when we're reaching OPEC's spare capacity exhaustion, which I've described as one of the biggest positive catalysts for the energy sector in modern history.

Michael Hainsworth:
Well, spare capacity diminishing isn't the only factor here. We're looking at low investment into building up that capacity and we've got low inventories as well. We sort of have a triple threat.

Eric Nuttall:
When you look at the oil market, people... Look, I've been doing it for 19 odd years, some people much longer than that. And consistently, most people say this is the tightest market they have ever seen, because it's been long-term trends that have allowed us to arrive where we are today, combined with the unique impact that COVID had on the demand shock. And now on the flip side, on the demand recovery, when we look at the trends of ESG investing, they happen to be pressuring capital spending on the part of the supermajors at the same time that spending on new projects peaked in 2014 and has been declining pretty much ever since.

And so we've had eight years, give or take, of insufficient investment. And now these companies have the requirement to take capital that would've gone into conventional oil, given we're trading at $90 or higher, and instead they have to invest in low margin projects like offshore wind turbines and solar. And so that's 40% of supply that because of those reasons, in addition, they're under shareholder pressure to do buybacks and increase dividends, et cetera. That's 40% of global oil supply that's going to flatline up best for the next eight years.

When we think about OPEC, they've been struggling with low oil prices for six, seven years now. And I remind people, they don't have elections. It's not like if people are unhappy, you just get voted out of office. There you get voted out of being the benevolent dictator in some cases. And so what prevents that from occurring? There's a social contract between the regime, the monarch and the people. You get at subsidized power, subsidized jobs, free education, et cetera. And the flip side to that agreement is you don't go into the streets and demand regime change.

And so as these countries have been dealing with very low oil prices, the very last thing they would cut is spending on that. The easiest thing that they cut was investment in new productive capacity, because that corresponds with a period of low oil prices where you spend money today and you get no revenue for 4, 5, 6 years.

And then finally the most exciting thing is about U.S. shale. I've said we're in a post-U.S. shale hypergrowth world. So what the heck does that mean? For a period of time, meaning almost 10 years, any time there was a rally in the oil price, you would see a burst of U.S. shale supply. And that happened because capital markets, debt markets were wide open and growth investors were the shareholders. They wanted growth.

Fast forward to today where growth investors now own Tesla. Value investors are the owners of these businesses and it took them two years, but they successfully changed their [inaudible 00:10:58] of these businesses to go from growth-seeking to value-seeking, and rather than growing production aggressively to moderate it, if you grow at all, and to maximize free cash flow to allow for dividends and share buybacks. And so now you've had this codification, this requirement, this cash sweep on a quarterly basis.

So if shale companies ever wanted to go back and repeat the sins in the past, they would literally have to go to the owners of the businesses and say, "I know you've been enjoying this eight to 10 to 12% cash yield annualized, but we want that money back so that we can use it to go drill, because we know just how well that ended up the last time, where there was about a trillion dollars of shareholders' equity that got incinerated."

And so there's a wide variety of reasons why there are structural constraints on supply growth. I think demand for oil's going to grow for at least the next 10 years, but the real bullish case is not on demand. It's on supply and it's for the natural gating factors when it comes to the supermajors, when it comes to OPEC and when it comes to U.S. shale.

Michael Hainsworth:
So if we have U.S. shale discipline, what though of discipline out of OPEC on the other side, because the shale players weren't the only ones to loosen the spigots every time the price hit a certain dollar value? Do we not expect that at some point OPEC, which has been underproducing, has been capturing fewer dollars per barrel than they could, decide to ratchet up either production or at least output from what they already have to capture more of those dollars? Does $100 not act as a psychological moment for the industry?

Eric Nuttall:
It's a very good point to raise, because it's true that many of the OPEC members are underproducing their quota. And so why is that? Is it benevolence? Is it their willingness to forsake hundreds of millions of dollars per month in necessary revenue as a state? Or is it evidence that many of them had been underproducing or sorry, underinvesting in their productive capacity over the past four, five, six years. And therefore, even as oil is declining, they lack the ability to ramp production because you're victim of cycle time, meaning you spend money today, it takes years to bring on that production.

And so we're seeing, I think the evidence, both within OPEC and non-OPEC countries, where we battle globally a decline rate every year. You lose production every year just through natural decline. So you always have to spend money just to stay flat, but we've had too many years of insufficient investment where now the decline rates are really kicking in and that's at the same time as we've had normalizing demand and the point that we've raised earlier is you're going to have surging demand later this year as people get out and travel again.

And so I think the exhaustion of OPEC's spare capacity... Outside of Saudi and the UAE and maybe Russia, there's very, very few available barrels floating around the market, and so once that becomes more evident, once that idea becomes more mainstream, once it becomes realized that the historical shock absorber in the oil supply chain from any geopolitical event, now that that is no more, then we can start talking about introducing a political risk premium into the oil price, because we haven't had to do that for many, many years.

Michael Hainsworth:
Well, let's get into that because we're dealing right now with a very interesting situation developing out of Europe, particularly with the Russian stranglehold on natural gas. Would that have an impact on oil prices?

Eric Nuttall:
Not specifically, other than oil-linked contracts for LNG. You've seen a surge in demand for global LNG as Europe's been scrambling. You build a power grid based upon renewables. And the challenge with that is sometimes the sun doesn't shine and sometimes the wind doesn't blow. And so when the wind power drops to one tenth of what you were expecting, you scramble, because you've been mothballing coal plants and natural gas plants, et cetera, nuclear plants.

So there's been a global call on LNG, a global call on coal. LNG was trading, I think the equivalent hit $300 per barrel equivalent. So that's been impacted by weather events and then both from lack of renewables, lack of baseload and then cold weather as well. So in my mind, that's a short term theme. Really what excites me is the visibility, I think, of 10 years plus of demand growth combined with ongoing structural challenges on growing supply.

Michael Hainsworth:
Another potential and many would, I assume, hope to be a short term issue would be the continued globally high inflation rate. What does that mean for the price of a barrel?

Eric Nuttall:
Yeah. It's an interesting question, because it has implications in terms of foreign policy on the part of the Biden administration. Here you have a president suffering from, I believe, record low approval ratings, heading into a midterm election where the primary concern of people is inflation food, energy, et cetera. So gasoline's the biggest constituent of that. So in my mind it does increase the likelihood of a deal being struck with Iran, which would free up floating storage in addition to allowing them to increase their production by about 700,000 barrels per day.

You can kind of see... If you read the tea leaves, I think you can see overtures in recent days alluding to that. So that could present headline risk for the matter of a few days perhaps. But I think it won't take that much time for investors to realize that the market is woefully undersupplied. We really need those barrels. And given how underowned the energy sector is at a time when energy stocks are discounting an oil price of roughly 60 and we're trading at 90, would a four or five dollar sell-off mean you get this massive crescendo sell-off in energy stocks? I don't think that's the case. I think people will be standing in and buying any dips.

Michael Hainsworth:
You argue that people are thinking that we'll all be driving electric cars in the next two years or so. And that that perception, whether or not it's reality, is actually good news for oil investors. We should walk through that idea.

Eric Nuttall:
Yeah. I've talked a lot about a theme called energy ignorance, which I define as the lack of knowledge of how oil is used, but more importantly, the likely timeframe for alternatives to displace the usage of oil and the reason why it's important, and the reason why energy ignorance is creating a generational opportunity for investors, is that as people believe the noise and that we're all driving electric cars, et cetera, yes, they are [inaudible 00:17:40] how oil is used. You'd probably say, "Well, I am 90, 95% of it's gas I burn in my car. I hear we're all driving electric cars. We don't need the stuff."

And so that misperception makes investors not wants to pay for barrels that are going to be produced 3, 4, 5, 6, 7, 8 years from now, because if we're not using the stuff, clearly there's no value for it. And it's a reason why, when we look at valuations in Canada, the average company's sitting on about 15 years of drilling inventory, and yet at an oil price 10%, 12% lower than where we are today, they could privatize with just four years of free cash. So they can literally buy every single share outstanding out of free cash flow while keeping production flat. And so if they can do that in four years, but they've got 15 years of reserves, the simple math is you're getting 11 years for free, 11 years of production, 11 years of free cash flow, 11 years of a dividend outlay of as much as 26 to 40%, depending on your oil price. And so you can get value for nothing.

And the reason you can get that today is energy ignorance. The average guy just has no clue that everyone listening to my voice will be using oil for the rest of their lifetimes. And if you just... Wherever you are right now, look around. Everything you see is either made of oil or require oil and hydrocarbons to make manufacture, transport, et cetera. And so this belief that we're going to be getting off oil in the next couple of years is the pinnacle of ignorance. And you could use much stronger language than that, but we'll keep it polite.

Michael Hainsworth:
Okay. When we look through 2022, it sounds like what you're saying is stick with the small to mid-cap stocks.

Eric Nuttall:
My bias is there, because when I think about how inefficient the market is today because there are so few players left, when I can buy quality for the same as junk, when I can identify opportunities that... We buy stories. So the difference between a cheap stock and a value trap is there has to be a catalyst. There has to be a reason why the market will view it differently in the future than it does today.

And so you can buy companies, in some cases literally with no debt, where they have a minimum 10 years of inventory, where they're meaningfully buying back shares and perhaps they're delineating a new play. Maybe they have exploration results or exploration upside that the market's not paying attention to. Where if you just spend the one hour getting to know the story, you can identify a stock where you see meaningful upside based upon what they already have and you're getting free optionality on exploration, et cetera. There, there are so many opportunities like that.

So it would be easy to think like, "My God. This sector's been such a strong performer. The trade's over." When I do my best to quantify potential upside, I'm still extremely excited. We wrote we see more than 120% up side for the sector and that's just using a hundred dollar oil. I think we're going to go meaningfully higher than that over the next several years. And so I'm still focused on Canada, because we have positive rate of change from building out pipelines, our differentials going forward, the discount at which we sell our oil versus the global benchmarks, I think will be permanently low.

And that's been the biggest reason why energy investors have shunned us. Well, that concern is no more. And so you'll see capital coming back. And in fact, we are. Our stocks traded at a discount relative to our U.S. peers for zero reason. We have better balance sheets. We have longer reserves. We have as much discipline on returning capital. And then in Canada again, the small and mid-cap, you just kind of get the gravy of that inefficiency and pricing. That target-rich environment, where you can find really, really exciting opportunities that people are just asleep to.

Michael Hainsworth:
So if the next big event or the data point for energy investors is earnings season, what are the red and green flags you'll be looking for in the reports?

Eric Nuttall:
I'm hopeful that another strong quarter of earning seasons that increasingly... Every reporting season, you have a higher and higher oil price. You'll have strong natural gas prices. And so the cash flow, the free cash flow is, is getting more and more and more stronger and stronger and stronger.

And what I'm looking for is the continuation of the theme that we've been a champion of. And that is to shake the generalist investor from their apathetic coma. What they need is meaningful action in the form of dividends and buybacks. And so what I want to see are companies affirm that they've been using their buybacks, which we can see in filings. That's not a shocker to me, but not everybody pulls up the filings and whatnot. What I want to see is the dedication to returning at least 50% of their free cash flow back to investors. The runway to dividend increases, the runway to implementing dividends for the first time, because it's going to be that consistent behavior, that consistent action of returning capital back that you... It's kind of like a stacking. One guy does it, then the next company and the next company and momentum begets momentum, which begets more momentum.

And eventually it just creates such an overwhelming force that that, combined with already strong share price performance, will be too much for the generalist to endure and to avoid this sector. Even the most of the divestment community... The mortal weakness of every fund manager is, I can be fired by a client at the click of a mouse button. And what prevents that from occurring is performance. That's what we're paid to do. And so you cannot avoid a sector with such a enormously strong momentum, with such awesome macro backdrops, much longer.

Michael Hainsworth:
All right. Now as I mentioned, I've been over the course of this conversation playing Eric Nuttall Bingo, courtesy of your Twitter feed. And I sort of feel like I'm cheating a little, because the two Xs on the three part row that I've got so far were words that came out of my mouth, not yours, U.S. shale discipline, and the number one performing energy fund. But if I'm going to get bingo, I'm going to need you to at least give us one of your key phrases. And I'm going to cheat again. And I'm going to let you help me out here. The first half begins with fear of peak demand, leading to...

Eric Nuttall:
The reality peak supply.

Michael Hainsworth:
Bingo!

Eric Nuttall:
Yeah. It's a key theme of mine. Yeah. And we're seeing in real time, and it's exciting to see the fear of peak demand is leading to the reality of peak supply.

Michael Hainsworth:
Eric, great speaking with you as always. Thank you again.

Eric Nuttall:
Thanks so much.

 

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

 

 

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