By Henry Bonner ([email protected])
Eric Nuttall is a Lead Portfolio Manager with the Sprott Energy Fund; he has been especially interested in the Canadian oil and gas sector, which he believes is undervalued now. He says markets have over-emphasized the US oil and gas boom at the expense of Canada’s oil and gas producers. That means there could be room for stocks in this sector to grow, especially if oil producers in the US fail to keep up their rapid pace of production increases.
The big star of the oil industry over the last two years has been the United States. In 2012, oil production reached 6.5 million barrels per day from around 5.7 million in 2011 – an increase of around 800,000 barrels per day.1 In 2013, production rose another 1.2 million barrels per day, and the U.S. Energy Information Administration expects it to see another 1.3 million barrels per day in 2014.2
Eric is not so sure. Can US oil keep up the pace?
“A potential outlier that could affect sentiment for US oil stocks is a disappointing growth rate for oil production. Production will probably continue to rise this year and next, but I think we will see a tapering out in the rate of growth,” he says.
“This could catch many by surprise given the overly-simplistic assumptions that people make about the sector. Many expect a straight-line annual increase of around a million barrels per day – a trend that has been in place for only two years.”
And if the rate of the increase begins to taper off, so too could the notion of US oil independence within the next decade… which Eric believes is a ‘complete fairytale.’
“That’s an exciting opportunity to make money if attitudes change,” he says. “The notion that the US would stop importing oil has dampened sentiment for the Canadian oil and gas producers.”
In fact, there is a simple reason that the US probably cannot keep up the rapid rise of oil production. Increased supply will lower the price, and oil from unconventional sources is expensive to produce.
“Some are suggesting the growth in US oil supplies will create downwards price pressure on oil. If it is too severe, the lower oil price should be a self-correcting process, especially at WTI prices below 90 dollars a barrel,” he explains.
This means US oil production cannot grow too fast and that the price of oil cannot drop too much, he says.
The market is overly-negative on Canadian oil companies, Eric believes. A lack of pipelines has caused fear that oil production will have no way of getting to market. But the industry has managed to get a surprising amount of oil out via train, he says, and he is optimistic that at least one of the two main pipelines proposed in Canada will see the light of day.
“The market is not yet realizing the significant impact of rail capacity. Several years ago, the amount of oil shipped by rail was zero, but by the end of 2013 we had the capacity to transport 375,000 barrels of oil per day by rail. We should see the industry continue to build that aggressively, with capacity set to reach 900,000 barrels per day by the end of 2014.3
“Effectively, Canada will have built the equivalent of a 1 million barrel per day pipeline in four years, although the transportation cost comes out at around twice that of a pipeline.”
Growing Canada’s oil industry will also require new pipelines, Eric believes, transporting it either to the East or West coast, where it can be sold on the international market. The Northern Gateway pipeline, which would send oil to the West coast of Canada, may not materialize because of issues concerning its path through First Nations lands.
Eric believes the Energy East pipeline, which would take oil to the East coast, has a good chance of being built. If it gets the ‘go-ahead,’ it could add export capacity for Canadian oil of around 800,000 barrels of oil per day.4
Lifting of the US oil export ban, which has been in place for several decades, would also aid Canadian oil producers. Eric is encouraged by increased political dialogue around the subject but says he is not convinced that the ban will be lifted.
On the broader international market, Brent crude production has not increased much despite sustained prices above $100 per barrel for Brent. Eric believes this is a bullish sign for WTI and Canadian oil because it probably means international producers are unable to up production despite higher prices.
Because production will stay bounded, he believes the price of Brent will be around $110 per barrel for 2014. WTI crude is likely to trade $10 lower and Canadian oil at an additional $10 discount due to transportation constraints.
The deterioration of the Canadian dollar – down 5% this year – has a significant positive impact on Canadian oil companies, says Eric.
“We are now at the first time in 16 months where the price of oil in Canada – after taking into account the differential – sells for more than it does in the US.
“This has a very powerful effect given that the cost structure in Canada is much less than in the United States. Most Canadian wells owe a royalty of around 5% of their production to their financers, but in the US they generally owe over 25% of their production. This means the cost of financing is lower for Canadian oil companies, despite the fact that they are about as efficient with the capital.”
Slower rates of increase in the US coupled with more improvements in the Canadian oil supply chain could heat up sentiment towards Canadian oil producers, Eric believes. The economics of these companies also become more attractive because of lower royalties due on production and the weakness of Canadian currency.
“I think that because of these factors, the under-appreciation of the Canadian oil and gas sector is finally coming to an end in 2014,” he concludes.
Eric Nuttall is a Portfolio Manager with Sprott Asset Management LP. He joined the firm in February 2003, and over the years, his views on the oil and gas sector are frequently sought by the Business News Network (BNN), a regular contributor to Alberta Oil Magazine, often interviewed by The Globe and Mail, the National Post, the Calgary Herald, and has appeared in both the Wall Street Journal Asia and Barron’s.
Eric is Lead Portfolio Manager of the Sprott Energy Fund, and co-manages the Sprott 2012 and 2013 Flow-Through Limited Partnerships with Allan Jacobs. Eric is a key contributor to Sprott’s internal macro energy forecasts, and supports Sprott’s portfolio management team by identifying top performing oil and gas investment opportunities.
Eric graduated with High Honors from Carleton University with an Honors Bachelor of International Business.