What Energy Stock Would You Buy?
Pitch me a stock is a question you are certain to get in any investing role or for equity research. You will occasionally get “pitch me a stock” in investment banking, but will not be required to go as in depth. For research and investing roles at any hedge fund or asset manager, your pitch will be attacked and you will need to really know the company and its numbers.
When asked for a stock for an oil and gas or mining team, there are a lot of nuances unique to these companies that are not present in pitching a “normal” business – primarily because the “inventory” they hold (their oil and gas reserves and resources) are 1) finite and 2) have fluctuating prices.
- Accordingly, at the junior level which involves prospecting and execution risk, cash flow and earnings multiples are less meaningful than valuation metrics that look at the underlying reserves – for instance, P/NAV. Once companies are more senior and have more diversified streams of income from different assets, cash flow becomes more relevant.
- Due to the price of their product fluctuating daily – and the product being a commodity, necessitating that all but the largest producers of oil and minerals to be price takers, the top line of the income statement is not as certain as a toy manufacturer that sets its retail price for the year. As such, prices will often reference two “price decks” – one that is the view of the investor (which may be in turn based off of company budgets and guidance) and one that is the current futures strip for oil and gas. Strip pricing is important because theoretically the company could lock in that value via hedging via forwards or other derivative structures with banks
- With metals and minerals being a far less liquid market than oil and gas, the futures strip is less relevant, so it will be more dependent on assumptions from the investor or research houses such as Wood Mackenzie. Given the relative lack of certainty from oil, miners are riskier – all things equal, and investors will expect higher returns
Here is an example of an energy idea and what interviewers will be looking for.
Canadian Natural Resources – Strong Cash Flow, Quality Assets, Flexibility, Strong Management Team
Canadian Natural Resources (CNQ) is a major, diversified (both in production mix and geography) international oil & gas producer that is expected to produce 1.1 million (MM) barrels of oil equivalent (boe) per day in 2018 and 1.2MM boe/d in 2019. This is heavily liquids weighted to the tune of 800kb/d.
CNQ has strong cash flow from low cost, low decline and long life oil and gas assets with ample development opportunities. In addition to internal cash flow, there is ample liquidity from significant capacity from revolving credit lines from banks as well as good access to debt and equity capital markets where it is a seasoned issuer.
The company has an experienced management team that is aligned with shareholders and has a record of execution and capital discipline. The current cash flow it is generating make several avenues for returning capital to shareholders possible.
Valuation of Canadian Natural Resources and Price Target
Currently, CNQ trades at around $39, implying a $45 billion market capitalization. With around $23 billion of debt (and net debt, as CNQ has a low cash figure), this is a 2018 EV/EBITDA of around 7.5x (based on a $52 WTI price deck) – around 0.5x higher than its peer group. CNQ has historically traded at a premium. CNQ is not hedging production and assuming production goes up to 1.2 million boe/d in 2019, this is a healthy ~10% return over the next year before a ~3% dividend which will likely be bumped up.
Oil & Gas Production Cash Flow
At management’s budget forecast based on the October 2017 futures strip, 2018 funds flow from operations is expected to be ~$8 billion with capital expenditures of $4.3-$4.5 billion dollars. Of that capex figure, $3 billion is maintenance or sustaining capex – capex that is required to keep the company producing at the same level, which means that in any oil price downturn CNRL can ratchet down spending.
This budget was set with WTI at $52 whereas there has been material appreciation in the oil price, albeit muted by widening differentials and a challenged Canadian gas market.
This large expected free cash flow can be returned to shareholders via an increased dividend, where CNQ has been a dividend aristocrat where it has continuously bumped up its dividend on an annual basis or share repurchases.
When pitching the stock, it is easy to grab an equity research report. Unlike other industries, natural resource energy reports can become dated very quickly if there are pronounced changes in the commodity price – a good interviewee will need to reconcile changes, or argue why the price deck used in the equity research report is a valid long term oil price. This requires a good understanding of the oil macro.
Canadian Natural Asset Quality
CNRL has a large, quality asset base across various top-tier Western Canadian basins. CNRL has 12 billion in 2P reserves across the Montney and various oil sands projects that provides a mix of short-cycle, high margin cash flow opportunities in conventional oil and gas production as well as scalable long-life (over 50 years) oil sands projects.
So for existing assets, CNQ can just keep producing the same massive volume each year, only needing to spend $3 billion in maintenance capex to take care of its 9% decline rate while generating substantial free cash flow.
However, projects have upside well beyond the run-rate figures. Through acquisitions from Shell (the Athabasca Oil Sands Project or AOSP) and Cenovus (Pelican Lake), CNQ can realize synergies due to the proximity of their legacy projects to these new assets and undertake debottlenecks and other initiatives to get more oil out and get it out more cheaply.
CNQ is also the largest landholder in the Montney, which is one of the most premier plays in North America at present due to its large hydrocarbon reserves, excellent geology (therefore low cost), and decent infrastructure. CNQ has large swaths of undeveloped land there and owns and operates a lot of its takeaway and processing capacity for gas, which allows it to realize good economics.
Oil and gas stocks are still theoretically the present value of future cash flows. If the assets are in the middle or higher end of the cost curve, a downwards swing in the commodity price can make current production uneconomical. A lack of developable reserves may mean that they may run out of product to sell.
Flexibility – Strong Liquidity and Access to Capital Markets
As alluded to above, CNQ has ample internally generated cash flow.
CNQ has ample liquidity through secured, revolving credit lines via a large relationship bank group that lasts as long as 5 years. CNQ also continuously takes out term debt and pays it down – banks are comfortable with their financial conservatism and markets have rewarded them with a premium to their peers on a valuation basis, making their stock attractive acquisition capital.
CNQ is an opportunistic acquirer, so this liquidity gives them a large battle chest to be used when there is an asset that is the right fit. However, CNQ has a history of being disciplined and has noted that there are no holes in their portfolio at present.
During the oil price collapse in 2015, most non-OPEC producers were not seeing the required returns on production (15% return on equity) and many were cash flow negative. Canadian oil assets have been historically high on the global cost curve, so many companies were bleeding money – companies that were pursuing production growth organically (capex) and inorganically (mergers and acquisitions) – having access to money is paramount in staying afloat and being opportunistic in terms of buying distressed assets at great prices while your company’s balance sheet is strong
Management Team – Aligned With Shareholders
The management team has been with the company for a very long time, taking CNQ from a penny stock to one of the largest independent exploration and production names in the world. There is a track record of execution in terms of getting projects completed on time and on budget while insiders hold a significant amount of CNRL stock – to the point where it constitutes a large portion of their net worth.
This alignment with shareholders has been evidenced by long term thinking, prudence on generating returns on capital instead of production growth, being cognizant of generating cost inflation and being opportunistic with acquisitions that have the right fit.
This is key for oil and gas investors – good ones always ask for the management team and look at their track record with previous oil and gas firms.
Companies that loaded up on high yield debt during $120 oil are not looked upon favorably and the reputation stays with the management – companies that end up losing a lot of money for shareholders via precipitous share price declines sometimes change their names.