Eric Nuttall: Looking for Oil and Gas Values, Not Value
Source: George Mack of
Sprott Energy Fund Portfolio Manager Eric Nuttall wants an edge
when he can find one. He's bullish on oil, but he prefers to play
the good oil story, not the commodity. And even though he's bearish
on natural gas, he's finding names that may provide exceptional
growth. Eric shares his best ideas in this exclusive interview
The Energy Report.
: APACHE CORPORATION - BANKERS PETROLEUM LTD. - CHENIERE ENERGY
PARTNERS L.P. - ENCANA CORPORATION - EOG RESOURCES, INC. - LEGACY
OIL & GAS INC. - OPEN RANGE ENERGY CORP. - PAINTED PONY
PETROLEUM LTD. - SUNCOR ENERGY INC. - VERO ENERGY INC. - WESTFIRE
The Energy Report:
In 2010, the Sprott Energy Fund outperformed its peer
S&P/TSX Capped Energy Index (32.6% versus 11.7%). In fact, the
fund outperformed the index in five out of the last seven calendar
years. What's the formula here?
We really try to look for opportunities where we have an edge
over our competitors. That typically leads us into the small- and
mid-cap energy space, where we think the outlook is very positive
over the next couple of years. We believe the fundamentals for oil
are now very solid. And we think there's been a huge disconnect in
the performance of oil and gas (O&G) stocks relative to what
the commodities have done.
You're bullish on oil. Tell us why.
What I fall back on is supply and demand data, which I find
to be very reliable. Despite an increase in weak economic data
points in several developed economies, I still believe that the
world oil market will tighten heading into the fourth quarter of
this year (Q411). We entered 2011 in a state of being undersupplied
by about 1 million barrels of oil per day (MMbpd). So, it wasn't a
surprise to me back at the last OPEC meeting that Saudi Arabia was
trying to increase actual production by about 1 million barrels.
The recent release from the Strategic Petroleum Reserve (
) is nothing but a politically motivated move to try to suppress
the price. While this may create a ceiling of around $90/bbl for
the next several months, demand has been surpassing supply and the
market is becoming increasingly tight.
The oil demand story is about emerging economies. China was
responsible for 33% of incremental demand in 2010, and in the most
recent data from May, demand is up 13% year-over-year (YOY). China
now consumes more than 9 MMbpd, a net change of over 1 MMbpd. I'm
looking for demand destruction in the developed economies; however,
incremental net demand out of China, India and even parts of Africa
more than outweighs that demand destruction. The oil market is
tight today, and I think that it'll continue to get increasingly
so. Today, we consume 89 MMbpd globally; if the world continues to
increase demand by roughly 1-2 MMbpd per year, it's very easy to
see a scenario in which OPEC spare capacity could get down to 1
MMbpd within the next two years. In that environment, I think the
price of oil has to go higher.
When you last spoke to
The Energy Report
in the fall of 2010, you said that equity valuations-not
commodity prices-would be your guide. Since that time, Brent Crude
is up about $30/bbl or about 40%. Have you become a bit more
commodity-driven since then?
I wouldn't say so. I think Brent is a more relevant benchmark
to use than is West Texas Intermediate (WTI) because of the
landlocked-storage issues that Cushing, Oklahoma has been
experiencing. So, when I look at a $105/bbl Brent price, it tells
me that world oil demand is very, very strong. But at the same
time, my forte is not top-down analysis of the commodity
markets-it's trying to find mispriced stocks. I personally believe
that global supply and demand now support a price of approximately
$100/bbl WTI, so you could call it about a $110/bbl Brent price. I
think that price level is defendable for the next couple of years,
with an upward bias toward maybe $5-$10/bbl per year.
In that environment, I think there are some incredibly cheap oil
stocks in the sub-$2 billion market-capitalization range that are
trading at under 4x enterprise value to cash flow (EV:CF); they are
growing production by 30%, 40%, 50% per year and they have very
clean balance sheets and a lot of exposure to emerging plays. It's
the best of all worlds. You've got dirt-cheap stocks with a
tremendous amount of upside. The amount of fear in the marketplace
today is the highest I've seen since 2009. One of my best lessons
from the Great Recession is that where there's fear, there's
opportunity. I think there's a tremendous amount of opportunity in
this subset of the market right now.
Then, clearly, you are finding compelling valuations.
And we'll get to that, but let me bridge to this. Are you
currently bearish on natural gas?
I am. I believe that it's going to be capped at around $5/Mcf
(thousand cubic feet). I think we're stuck in a $4-$5/Mcf trading
range until 2015, at which time North America will become an
exporter of natural gas. In Canada, the Kitimat LNG (liquefied
natural gas facility) will be constructed by around 2015. Kitimat
is jointly owned by
Apache Corp. (
EOG Resources Inc. (
Encana Corp. (TSX:ECA; NYSE:ECA)
. In addition,
Cheniere Energy Partners L.P. (NYSE.A:CQP)
got expanded approval to be a natural gas exporter. I think we're
going to see a lot more
facilities on the Gulf of Mexico seek approval to become
Technology has unlocked an unbelievably large amount of natural
gas that is now quite economic at low prices. Four or five years
ago, I would've said the required price to achieve a decent
economic threshold was $7/Mcf. Today, I think that threshold is
about a $4-$5/Mcf price among most of the shale plays, which would
-the largest sources of new supply in both the United States and
North America. Rig count has continued to expand in all of those
plays. Even in a depressed natural gas price environment, producers
continue to drill.
Demand is growing as a result of coal substitution and lower
nuclear power plant utilization, but l still think supply is
overwhelming demand. Again, until we become an exporter, we're
looking at a $5/Mcf ceiling price because if we ever get above
that, every single gas company in North America will be trying to
hedge to be able to lock in a very active capital-expenditure
So, you're saying there's a real arbitrage opportunity for
some nat gas producers to export to Asia and Europe?
Yes, there's a huge arbitrage in that. The global LNG pricing
on average has been around $10-$12/MMBtu (million British thermal
units). There are times when it spikes due to seasonal factors, but
there's a huge price differential. That's why I think the plays
that are close to key export terminals are going to become highly
strategic. Some of my top holdings are companies involved in what I
think will become increasingly strategic areas.
For many reasons, energy has been a natural growth sector.
How do investors play this today?
I look for companies in which I think I have an edge in my
analysis to determine if they truly are undervalued, or whether
they're just value traps. Because we've seen names fall 10%-15% in
May, and then by another 15%-20% in June, you could almost throw a
dart at a board and make money in the energy sector over the next
couple of months. But where I'm finding value, and where I think
you get the best risk/reward, is in companies that are levered to
oil that are in that sub-$2 billion market-cap space. There are
also opportunities in the natural gas space. In a $4-$5/Mcf
gas-price environment, some companies are earning about a 75%
margin. I'm looking where the risk/reward of an investment
opportunity is highly, highly skewed to the upside.
Skewed to the upside. Could you give me an example of
Well, we could walk through some of my top holdings. That's
probably the best way to understand my style.
In terms of size, my largest current position is
Legacy Oil & Gas Inc. (
. It's a $2 billion-market cap light oil company, and it's a case
study of how we try to look at things differently. There was a
management change within a major shareholder, Fidelity Investments,
and the manager had to blow out 18 million shares. That took the
share price from $17.50 down to around $11.50; not for any
fundamental reason-it was due to fund flow. The stock trades at
around $12 today, but I was aggressively buying at around $12.50
and was buying every share I could at around $11.50.
When I started buying LEG, I was paying the lowest multiple of
price-to-cash flow in its corporate history. and I thought my
downside was limited to commodity and market risk. I knew the
company had very significant exposure to several emerging plays,
including the Spearfish in North Dakota and the
, which is an emerging tight oil play. So, I paid a very low
multiple and got all of the upside free. I could see the stock at
$16. So, while a 33% upside from today's level doesn't sound super
sexy, it's decent; and I think my downside risk is very low. The
company is managed by, in my opinion, one of the best light oil
teams in the business, which is comprised of proven value creators;
and the balance sheet is very clean.
I note the company went from operations cash flow of $26.3M
in Q110 all the way up to $43.9M in Q111. Can that kind of growth
Yes, I'm looking for more than $300M cash flow in 2012. That
would put the company at 6.7x cash flow today, and I think it can
grow production by 15%. Legacy's about 80% levered to the price of
light oil. It's got all of the different aspects I look for.
My second-largest position is
Painted Pony Petroleum Ltd. (TSX.V:PPY.A)
, and this is an example of how you can be bullish on natural gas
names without necessarily being bullish on natural gas. The company
has a market cap of about $700M and, in terms of production, it's
equally split between oil and natural gas. Painted Pony has assets
in Saskatchewan, which is typically a light oil-weighted basin, and
northwest British Columbia, which is a real upside. But what I
really liked is its very clean balance sheet; this is a very
debt-averse company. PPY has a five-year drilling inventory in
of the Saskatchewan Bakken play, where the economics or
for the required price of oil is very, very low. When I
started buying the stock, it was trading very cheaply on current
production. Legacy appears to be in the sweet spot of the
play in Canada. I think fair value on existing production is
up to $30, but I don't think the company will be around long enough
to realize that.
So, 175% upside from here?
Again, I don't think it will be around that long. It could be
easily taken out from $17.50-$20/share over the next year or two.
Internally, I think fair value is around $20/share. So, I'd be
comfortable saying it's close to 100% potential upside.
My third-largest holding is
WestFire Energy Ltd. (TSX:WFE)
, which is almost a pure play on an emerging tight, light oil play
in Canada. The company has spent several years aggregating
acreage in this play, and I believe it has about 800 risked
locations. If one believes in $100/bbl oil, then that works out to
about $25 of risked value per share-and the stock is trading at
$6.85 now and at 3.9x 2011 cash flow. It's very, very cheap on
current production. WFE's balance sheet is healthy, and I think
production will grow by more than 20% in 2012 over 2011. I like the
management; the team members have a lot of their own skin in the
game, so they're highly motivated to sell the company when the
right time comes.
WestFire was your largest holding at the end of May, was it
It would've been a few months ago. I haven't sold any shares.
It's been weak relative to a couple of other names.
My fourth-largest holding is a company called
Open Range Energy Corp. (TSX:ONR)
. This is an interesting name because if we had talked nine months
ago, I would've told you it was an economic natural gas company
that was growing production strongly. But what's really transformed
the story is a very positive uptake on a new service business
called Poseidon Concepts. It's simply a way to store water that's
used to fracture stimulate natural gas wells. What it's created is
almost like a very large, inflatable aboveground swimming pool, as
opposed to hauling 20 or 25 truckloads of steel tanks. So, there's
a cost savings to ONR of more than $100,000 per job.
This business has grown from nothing to a
of about $80 million of EBITDA, which is just phenomenal. So,
that service business is growing strongly and the free cash flow
from it is being used to grow the natural gas business in the
Wilrich, where there's phenomenal natural gas economics. The
company has very strong growth on the natural gas business and, at
the same time, there's very good uptake on the service business.
And, it's dirt cheap.
You're a real value seeker, aren't you?
Well, it's important to distinguish between a value stock and
a value trap. A value stock can be a cheap stock with no catalyst
to revalue the company. I always look for names where I think my
downside's limited because it's trading at a cheap multiple based
on current production. At the same time, there has to be some
catalyst to the name-otherwise, the stock can languish at a cheap
multiple for years. Sometimes cheap stocks are cheap for a reason;
my job is to try to find those opportunities where, in my opinion,
the market is looking at something incorrectly.
You were going to mention another one?
After Open Range would be
Bankers Petroleum Ltd. (TSX:BNK)
. It's fallen from a high of $10 around the beginning of March to
near $7, and so the stock's down 30%. At the same time, it's marked
off of Brent oil, and it's developing the largest onshore oil field
in Eastern Europe, the Patos-Marinza field in Albania. Bankers is
producing around 12,000 bpd, and will be exiting at around
18,000-20,000 bpd at the end of this year. It's been very
successful at employing Canadian technology in an old field to
rehabilitate it and to grow production, primarily using horizontal
wells with good success.
Again, it's under a $2 billion market cap, which is where
Yes, it's that sweet spot. Larger companies are very
difficult. With a
Suncor Energy Inc. (TSX.V:SU; NYSE:SU)
or an Encana, which is a $40-$50 billion market-cap company,
it would be very difficult for me to have an edge over my
competitors. If I buy that company, I should expect to do as well
as the index. My unit holders are not paying me to perform as the
index would. They're looking for me to beat it. I'm looking for
opportunities in which I've got edge and that will typically lead
me to a sub-$2 billion market.
Do you want to mention one more company?
Another one would be
Vero Energy Inc. (TSX:VRO)
, which is a stock that's kind of fallen out of favor with the
marketplace. The management's done a very good job of growing
production over the years. On a production-per-share basis, it's
upward of around 22% from 2009 until now, yet it trades at a low
multiple. VRO's trading sub-4x EV to cash flow, despite
management's pretty good execution. Production is growing very
meaningfully, and the company is increasing the component of
liquids in the production stream. My hope is that Vero will sell
itself at some point this year or merge with another company
creating a high dividend-paying corporation and one exploration
entity that the Vero management team could lead.
Eric, these are very interesting names. Thank you very
is a portfolio manager with
). He joined the firm in February 2003 as a research associate and
was subsequently promoted to research analyst in 2005, associate
portfolio manager in 2008, and then to portfolio manager in January
2010. Eric is lead portfolio manager of the
Sprott Energy Fund
, along with Eric Sprott, and he also comanages the
Sprott 2010 Flow-Through Limited Partnership
with Allan Jacobs. In addition to his responsibilities for
those funds, Eric supports the rest of the Sprott portfolio
management team in identifying top-performing oil and gas
investment opportunities. Eric also contributes to internal
macro-energy forecasts, and his insight into emerging
unconventional plays has been covered in several financial
publications, such as
The Wall Street Journal,
Asia and Barron's. Eric graduated with high honors from
Carleton University with an Honors B.S. in international
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1) George Mack of
The Energy Report
conducted this interview. He personally and/or his family own
shares of the following companies mentioned in this interview:
2) The following companies mentioned in the interview are sponsors
The Energy Report:
3) Eric Nuttall: I personally and/or my family own shares of the
following companies mentioned in this interview: Painted Pony,
Westfire, Bankers and Open Range. I personally and/or my family am
paid by the following companies mentioned in this interview:
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