Get Your Natural Gas Shopping List Ready: Eric
Source: George S. Mack of
Natural gas is cheap, but it's going to get cheaper. Eric
Nuttall, lead portfolio manager of the Sprott Energy Fund,
expects the bottom to fall out of the natural gas market as soon
as this summer. But he's not all doom and gloom. In fact, he
argues that natural gas is about to give investors the buying
opportunity of the decade. In addition, Nuttall forecasts
spectacular growth for oil-weighted juniors. In this exclusive
The Energy Report
, he urges investors to get their shopping lists ready for a
massive sale in natural gas names.
The Energy Report:
Eric, in your Q411 market commentary for Sprott Energy Fund, you
describe 2011 as a challenging year. What made the market so
difficult for investors?
There were several factors: First, the weather failed to
cooperate in Canada, where we had a very extended breakup in
southeast Saskatchewan. We had epic levels of rainfall. We also
had raging forest fires in parts of Alberta. The weather led to a
low level of activity for much of the first half of 2011, and
many companies struggled to fulfill their capex programs and meet
their production targets. Natural gas pricing was very weak,
which is something that I expect for the remainder of 2012.
Meanwhile, equity markets were very volatile. There were many
different factors, all of which oil and gas companies had to
You commented that despite the fact that, for the first time in
history, the price of Brent crude oil averaged more than $100 per
barrel (/bbl) during 2011, oil stocks languished. What was the
issue here? Are markets fearful of negative global macroeconomic
In a word, yes. European debt issues captivated the public's
attention for much of 2011, specifically worries about Italy,
Portugal, Spain and most obviously Greece. Today, those fears
seem to have abated somewhat, but there's still a tremendous
level of uncertainty. I think there's lingering psychological
trauma from 2008 and 2009 that encourages people to approach the
market from a fear-driven mode as opposed to a greed-driven mode,
meaning the appetite for risk is very low. You can see that in
mutual fund industry money flows, where the only funds that are
really garnering large cash inflows are dividend- or
yield-oriented funds. That indicates retail investors are still
worried we'll have some unexpected event that will lead to a
selloff similar to the one markets experienced in 2008 and 2009.
Most people simply can't afford to endure another one of
Let's shift our focus to oil price action. Oil is up about 3-5%
over the past 12 months, but it's basically flat. Is this a
period of consolidation? What does that mean for equities?
It is a period of consolidation, and share prices today reflect
that industry environment. Many stocks have descended well over
20% within the past two months. We've experienced a sharp selloff
even though oil prices have remained very strong, and it feels
like the market is oversold despite strong fundamentals. Although
we had a poor U.S. employment number for March, I think people
missed out on the operative word, which is "growth." Gross
Domestic Product growth in China may be slowing to 7.5%, but by
my math that still portends an approximate 400,000 barrel per day
(400 Mbblpd) increase in oil demand.
Nonetheless, some midcap stocks with market caps of under $1
) are growing production by over 50% with cash flow margins of
over 50% and solid balance sheets. Yet they are trading under
four times their enterprise value, which is very cheap. These
strong underlying fundamentals and extraordinarily inexpensively
priced stocks present a bit of a dichotomy.
You've discussed general market sentiment, but what is your
outlook? Are you bullish over the next 12-18 months?
Yes I am. The world economy continues to grow, and the world oil
market remains tight. We're eating through worldwide capacity,
including some of OPEC's vapor barrels.
Speaking of OPEC, political tensions between the U.S. and Iran
seem to have created a premium in oil. Electoral politics further
elevate these tensions. Could this result in a selloff in the
period leading up to the November 2012 election?
I would agree that there seems to be a political risk premium of
around $15-20 built into the current oil price, although supply
is in fact down about 800 Mbblpd since Iran sanctions were put in
place. But as far as how the election may affect price action, my
crystal ball isn't that clear.
Do you expect your sub-$1B market cap companies to continue their
pace of 50% production growth?
Without question. Many companies have put on some hedges, and I'm
a big proponent of that because investor risk tolerance has
decreased since the 2008-2009 period. Hedging used to be a
negative stigma for junior oil producers, the rationale being
that if the price of oil went above their hedges, they'd be
penalized; and if the price of oil dropped, the share price would
still go down despite the protection of the hedges. In today's
environment, people are more comfortable if an element of cash
flow has been protected so that capex programs are guaranteed
irrespective of the underlying commodity price.
That said, I'm looking at many of these companies that are
sitting on 10-15 years of drilling inventory, and in parts of
Canada they can get 5% royalty incentives for upwards of the
first 60-80+ Mbbl oil produced, depending on the well. The first
couple of years can be wildly economic. The situation is that
there is a strong commodity price, and for companies with hedging
in place and extended drilling inventory for 10, 15 or even 20
years, the outlook of that growth rate is well maintained.
So is this the sweet spot in energy right now?
That's a good question because it leads me to my current
strategy. Even with the risk premium for oil prices we discussed,
I feel that fundamentals will remain strong. Thus, I want to be
invested in oil through the subset of roughly $300M-1B-market cap
stocks that have been severely penalized in spite of the very
strong price of oil in Canada.
With natural gas, however, the fundamentals are
extraordinarily weak, and the outlook for the next several
quarters looks bleak. I expect this summer to be extraordinarily
volatile and weak for natural gas stocks. I don't think people
appreciate just how terrible the current situation is and what's
likely coming in the next couple of quarters. This summer, I
expect the market to reach a point of maximum pessimism, with
Canadian gas pricing below $1 per thousand cubic feet (/Mcf) and
U.S. pricing below $2/Mcf. In a scenario of maxed-out physical
storage, natural gas could become a no-bid. I think storage
levels both in the U.S. and Canada will fill, and that may lead
to a massive selloff. Ultimately, that could potentially lead to
the investment opportunity of a decade.
You're talking about classic economic theory, where a no-bid
would halt production and a rebound would eventually follow.
Yes. What's happened is that we've had the warmest winter in
about 60 years. It's been an incredibly hot winter, which has led
to very little heating demand in conjunction with, for a number
of reasons, high levels of production. With demand so low, supply
continues to increase, and now we are at a 900 billion cubic feet
surplus, which is unbelievably shocking. Canadian storage today
is around 83% full and we haven't even started the injection
season yet. All things considered, it's just a terrible outlook
for the next couple of quarters. And yet when you look at these
natural gas stock prices, they're expensive. Even at a higher gas
price, I still think the stocks are overvalued. I would not be
surprised to see a selloff of another 10%, 20% or 30% in many of
How do you interpret rumors of possible Asian demand for Canadian
natural gas, an eventuality many analysts are hinting at? For
recently reported that the CEO of Malaysian, state-owned
Petroliam Nasional Bhd (Petronas) says he wants to make a $5B
Canadian acquisition in the next three months in order to secure
natural gas supplies for Asia.
In that case, I think people are misinterpreting what the
gentleman meant. If you were sitting in his seat, the least
logical thing to do if you're planning a corporate acquisition
would be to foreshadow your move. What I think he meant is that
he intends on forming a joint venture (JV) agreement with a
company, such as an Encana Corp. (ECA:TSX; ECA:NYSE). I see the
$5B number he mentioned was more of a reference to drilling
costs; I'd be surprised if it referred to an outright corporate
acquisition. There's a tremendous amount of product on the market
right now, and given how capital-constrained many of these
natural gas companies are today, the JV is a more likely
scenario. Companies like ARC Resources Ltd. (ARX:TSX) and EnCana
are aggressively looking for partners to assist them on
Asian demand aside, what catalysts should investors be watching
for if they want to participate in the possible buying
opportunity in natural gas you discussed earlier?
That's a great question. One may have to be patient, but the
potential returns will incentivize being patient in terms of your
investment time horizon. First of all, we'll likely have to wait
for winter to get a sense of what the heating demand is for next
year. Continued decreases in the natural gas-directed rig count
would be another indicator. Finally, capitulation by investors in
these stocks as they fall precipitously on very large volumes and
in large blocks would be a key catalyst. People will just throw
in the towel. The ultimate catalyst may even be gas going no-bid,
when things frankly could not get any worse.
Rock bottom, in other words. Do you have any closing
In summary, I would say the underlying fundamentals for oil
remain strong, assuming the world doesn't slip into a global
recession, which I think is very unlikely. Stocks have been
extraordinarily weak over the past couple of weeks and months,
but if one can be patient, these stocks represent a very good
opportunity. As for natural gas, there will be a selloff in
equities in the next couple of quarters, and investors need to
have their shopping lists ready because these names are going to
go on sale.
Thank you, Eric. I enjoyed this very much.
Likewise. Thank you.
Eric Nuttall is a portfolio manager with Sprott Asset
). 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. He is co-manager of the Sprott Energy Fund along
with Eric Sprott, and also co-manages the Sprott 2010
Flow-Through Limited Partnership with Allan Jacobs. In addition
to his responsibilities for those two funds, Nuttall supports the
rest of the Sprott portfolio management team by identifying
top-performing oil and gas investment opportunities. Further, he
contributes towards 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
Nuttall graduated with high honors from Carleton University
with an Honors Bachelor of international business.
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1) George S. Mack of
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