Energy Markets: Our Current Thinking - Dan Lloyd, Portfolio Manager
In the near term it’s likely that Canadian (and all) energy names could take a breather but beyond the short term, we are unabashed bulls on the group. Touching on oil first, Canadian egress issues will soon be in the rearview as Enbridge’s Line 3 replacement pipeline comes into service later this year and the Transmountain Expansion starts flowing next year. This combination will add roughly 1mmbbls/d of export capacity, essentially making Keystone XL a ‘nice to have’ versus a ‘must have’. Canadian oil producers have significantly lower corporate declines than U.S. producers which will inevitably lead to much higher free cash flow, given their significantly lower sustaining capex requirements so as to keep production flat. To illustrate this point, during Q3 of 2020, collectively, the 20 largest oil producers in the U.S. produced 6.45mmbbls/d with a decline rate of 46%. As this decline rate includes production from the Gulf of Mexico, we would suggest U.S. shale oil declines are in the mid 50’s. This fact means U.S. producers have to sprint ever-faster on the treadmill just to maintain production. In contrast, Canadian producers in general, and more specifically the largest constituents of XEG (which is ~50% CNQ and SU) have corporate declines below 15%, allowing these companies to print cash above $40 WTI. Without getting too deep into the oil macro, we believe that notwithstanding a large setback in the covid vaccination rollout, demand will be very strong in the back half of the year and as a result, oil prices should remain buoyant. Our fund has always had a substantial energy allocation and 2020 was a perfect microcosm as our energy book made us money in both March (literally the worst month ever for Canadian energy stocks) and November (the best ever). During 2020 the energy book made money in 9 of 12 months while XEG was down 7 of 12. The largest positions in the energy bucket of our portfolios have several common characteristics: uniquely good assets, high free cash flow and management teams with a demonstrable track record of being good stewards of shareholder capital. Our favorite oil names are Canadian Natural Resources Ltd. (CNQ.CN), Parex Resources Inc. (PXT.CN) and MEG Energy Corp. (MEG.CN). At the moment we have net long positions in both oil and gas.
Shifting to natural gas, this market is particularly interesting right now as there are very different reasons to be bullish than we had envisioned a couple months ago. Warm temperatures in North America have been headline bearish for gas pricing to this point but interestingly gas draws through the withdrawal season (so far) have been average, and larger than last year (From Nov 1 through last week’s inventory report, 495 billion cubic feet of gas was withdrawn from inventories vs. 448 bcf over the same period one year ago). This inventory position is being driven by the fact that is extremely cold almost everywhere in the northern hemisphere other than central North American. This temperature variance matters more today than in the past because gas is slowly becoming a global commodity via the use of LNG rather than the strictly regional markets that have existed to this point.
To that point, North American LNG export capacity is running at full utilization every single day, helping to keep the North American gas market tighter than the domestic weather picture would suggest it would otherwise be. Current LNG exports exceed 11 bcf per day vs. roughly 6 bcf/d last year implying that on a weather neutral basis, the North American gas market is 5 bcf/d tighter than it was at this time last year just on LNG exports alone. Last point on LNG that helps illustrate our point is shown below in a Jan. 8th note from Tudor Pickering & Holt, noting that Asian pricing hit a record this week with a large cargo bound for South Korea selling for $20.80/mmbtu (!)…so if you have the facilities, buying your feedstock in North America at $2.70 is a reasonable arb. Coal to gas switching and much colder than normal temperatures will likely keep the gas market tight for 2021 as inventories will need to be replenished. US gas production is roughly 4 bcf/d below last year, adding to the structural tightness (for context, total US production is ~90bcf/d). So for what it’s worth, one cold blast in North America, which seems likely via a disruption in the polar vortex sometime near the end of January, should have an outsized impact on gas prices as the market is undersupplied on a weather-neutral basis. However, we’d point out that it’s exceedingly difficult to predict the weather so we don’t try. That said, the setup is there for strong pricing of $3+ in 2021 and beyond, particularly in Canada as coal to gas switching in Alberta will add ½ bcf/d of demand in 2021 and LNG will add another 1.5bcf/d a few years out (against total Canadian gas production of 17 bcf/d, so these demand adds are substantial). Our favourite gas names are Tourmaline Oil Corp. (TOU.CN), Storm Resources Ltd. (SRX.CN) and Trican Well Services Ltd.(TCW.CN) for service exposure to Canadian gas capex.
Then on Friday the 8th, energy focused dealer Tudor Pickering & Holt published the following commentary:
This week in global gas is basically a book of hyperbole:
1) Japan power prices hit the equivalent of $280/mmbtu as the Asia Pacific gets hit with some of the coldest weather in decades
2) Spain actually recorded the coldest temperature ever observed in the country’s history
3) Posted JKM prices moved over $20/mmbtu and bids were seen up to $26 for H1 Feb.
4) The combination of all these things has Europe posting its largest ever daily storage draw of 43bcf on Wednesday
All of this is making it very difficult to envision US LNG utilization dropping below 90% this year.
Bottom LIne: We suspect we’ll see prices for natural gas back above US$3 in the not too distant future. Also, while oil prices may pause here, the back half of 2021 is looking very good!
Thank you for reading
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