Eric Nuttall, partner and senior portfolio manager, Ninepoint Partners

FOCUS: Energy stocks

MARKET OUTLOOK:

Energy remains in a multi-year bull market with strong (enough) underlying demand growth and limitations to supply growth, be they voluntary curtailments by OPEC+ or natural gas producers, or productivity erosion in U.S. shale wells. We look forward to oil entering seasonally stronger demand months beginning in June leading to falling global oil inventory levels supportive of US$80 West Texas Intermediate (WTI) with a potential year-end target of $90. For natural gas, so long as Mother Nature cooperates this summer and liquefied natural gas (LNG) capacity continues to grow on schedule, we see better days ahead for natural gas pricing with a rough target of $4/mcf (thousand cubic feet) for 2025. This pricing along with a drawdown in the number of drilled/uncompleted wells over the past few years is supportive of a higher rig count in 2025, benefitting service stocks.

With the valuation spread between large and small-cap energy companies at record highs, we continue to see the most upside in smaller companies that are large enough to be relevant to more than a handful of global investors. Given in some cases free cash flow yields are still in excess of 20 per cent, we remain bullish on the outlook now and going forward as debt targets have been or will soon be finally reached leading to meaningful share buybacks. This results in an inevitable re-rating in trading valuations.

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TOP PICKS:

Baytex Energy (BTE TSX)

Baytex remains a deeply contrarian name given apathy towards mid-caps in general and poor share price performance over the past year (confusion of its acquisition + PE overhang). We think patience will be rewarded given deep value (2.3 times EV/CF, 29 per cent free cash flow yield), asset quality (drilling top decile wells in the Eagleford and Clearwater), and a CEO who has a proven track record (though unknown to the Canadian market still). We see fair value at four times EV/CF = $10.07 potential share price = 117 per cent potential upside.

Precision Drilling (PD TSX)

With 2024 being a neutral-ish year for service companies (low natural gas price = limited drilling). We like that we can justify ownership using conservative 2024 estimates while getting free optionality to a stronger year in 2025 given the need to drill gas wells to offset base declines and meet LNG demand growth. We believe the stock is trading at a 23 per cent free cash flow yield on 2024 estimates and 28 per cent free cash flow yield on our 2025 numbers. With the company returning around 35 per cent of free cash flow back to shareholders the company has the ability to retire 18 per cent of its stock over the next two years. Fair value = 14 per cent free cash flow yield = $207 target price = 117 per cent potential upside.

ARC Resources (ARX TSX)

Arc offers investors 20 plus years of stay flat inventory, production growth via Attachie, an ultra-conservative management team and board, and strong optionality to an improving Canadian natural gas environment. Using $4/mcf and $80WTI we have the stock trading at 4.1 times 2025 EV/CF and a 14 per cent free cash flow yield, with the company returning 55 per cent of free cash flow (after dividends) plus paying a 2.4 per cent yield. We see fair value at six per cent (10 per cent free cash flow yield ) = $38 target price = 50 per cent potential upside. 

PAST PICKS: MAY 31, 2023

Cenovus Energy (CVE TSX)

• Then: $21.69
• Now: $27.44
• Return: 26%
• Total Return: 30%

Headwater Exploration (HWX TSX)

• Then: $6.48
• Now: $7.22
• Return: 11%
• Total Return: 18%

Whitecap Resources (WCP TSX)

• Then: $9.29
• Now: $10.37
• Return: 12%
• Total Return: 19%

Total Return Average: 22%