Outlook for Canadian Oil and Gas in 2014: Eric Nuttall

By Henry Bonner (hbonner@sprottglobal.com)

Eric Nuttall is a Lead Portfolio Manager with the Sprott Energy Fund; he has been especially interested in the Canadian oil and gas sector, which he believes is undervalued now. He says markets have over-emphasized the US oil and gas boom at the expense of Canada’s oil and gas producers. That means there could be room for stocks in this sector to grow, especially if oil producers in the US fail to keep up their rapid pace of production increases.

The big star of the oil industry over the last two years has been the United States. In 2012, oil production reached 6.5 million barrels per day from around 5.7 million in 2011 – an increase of around 800,000 barrels per day.1 In 2013, production rose another 1.2 million barrels per day, and the U.S. Energy Information Administration expects it to see another 1.3 million barrels per day in 2014.2

Eric is not so sure. Can US oil keep up the pace?

“A potential outlier that could affect sentiment for US oil stocks is a disappointing growth rate for oil production. Production will probably continue to rise this year and next, but I think we will see a tapering out in the rate of growth,” he says.

“This could catch many by surprise given the overly-simplistic assumptions that people make about the sector. Many expect a straight-line annual increase of around a million barrels per day – a trend that has been in place for only two years.”

And if the rate of the increase begins to taper off, so too could the notion of US oil independence within the next decade… which Eric believes is a ‘complete fairytale.’

“That’s an exciting opportunity to make money if attitudes change,” he says. “The notion that the US would stop importing oil has dampened sentiment for the Canadian oil and gas producers.”

In fact, there is a simple reason that the US probably cannot keep up the rapid rise of oil production. Increased supply will lower the price, and oil from unconventional sources is expensive to produce.

“Some are suggesting the growth in US oil supplies will create downwards price pressure on oil. If it is too severe, the lower oil price should be a self-correcting process, especially at WTI prices below 90 dollars a barrel,” he explains.

This means US oil production cannot grow too fast and that the price of oil cannot drop too much, he says.

The market is overly-negative on Canadian oil companies, Eric believes. A lack of pipelines has caused fear that oil production will have no way of getting to market. But the industry has managed to get a surprising amount of oil out via train, he says, and he is optimistic that at least one of the two main pipelines proposed in Canada will see the light of day.

“The market is not yet realizing the significant impact of rail capacity. Several years ago, the amount of oil shipped by rail was zero, but by the end of 2013 we had the capacity to transport 375,000 barrels of oil per day by rail. We should see the industry continue to build that aggressively, with capacity set to reach 900,000 barrels per day by the end of 2014.3

“Effectively, Canada will have built the equivalent of a 1 million barrel per day pipeline in four years, although the transportation cost comes out at around twice that of a pipeline.”

Growing Canada’s oil industry will also require new pipelines, Eric believes, transporting it either to the East or West coast, where it can be sold on the international market. The Northern Gateway pipeline, which would send oil to the West coast of Canada, may not materialize because of issues concerning its path through First Nations lands.

Eric believes the Energy East pipeline, which would take oil to the East coast, has a good chance of being built. If it gets the ‘go-ahead,’ it could add export capacity for Canadian oil of around 800,000 barrels of oil per day.4

Lifting of the US oil export ban, which has been in place for several decades, would also aid Canadian oil producers. Eric is encouraged by increased political dialogue around the subject but says he is not convinced that the ban will be lifted.

On the broader international market, Brent crude production has not increased much despite sustained prices above $100 per barrel for Brent. Eric believes this is a bullish sign for WTI and Canadian oil because it probably means international producers are unable to up production despite higher prices.

Because production will stay bounded, he believes the price of Brent will be around $110 per barrel for 2014. WTI crude is likely to trade $10 lower and Canadian oil at an additional $10 discount due to transportation constraints.

The deterioration of the Canadian dollar – down 5% this year – has a significant positive impact on Canadian oil companies, says Eric.

“We are now at the first time in 16 months where the price of oil in Canada – after taking into account the differential – sells for more than it does in the US.

“This has a very powerful effect given that the cost structure in Canada is much less than in the United States. Most Canadian wells owe a royalty of around 5% of their production to their financers, but in the US they generally owe over 25% of their production. This means the cost of financing is lower for Canadian oil companies, despite the fact that they are about as efficient with the capital.”

Slower rates of increase in the US coupled with more improvements in the Canadian oil supply chain could heat up sentiment towards Canadian oil producers, Eric believes. The economics of these companies also become more attractive because of lower royalties due on production and the weakness of Canadian currency.

“I think that because of these factors, the under-appreciation of the Canadian oil and gas sector is finally coming to an end in 2014,” he concludes.

Eric Nuttall is a Portfolio Manager with Sprott Asset Management LP. He joined the firm in February 2003, and over the years, his views on the oil and gas sector are frequently sought by the Business News Network (BNN), a regular contributor to Alberta Oil Magazine, often interviewed by The Globe and Mail, the National Post, the Calgary Herald, and has appeared in both the Wall Street Journal Asia and Barron’s.

Eric is Lead Portfolio Manager of the Sprott Energy Fund, and co-manages the Sprott 2012 and 2013 Flow-Through Limited Partnerships with Allan Jacobs. Eric is a key contributor to Sprott’s internal macro energy forecasts, and supports Sprott’s portfolio management team by identifying top performing oil and gas investment opportunities.

Eric graduated with High Honors from Carleton University with an Honors Bachelor of International Business.

........................................................

--In reality, the Fed will be very nervous about what they have started. To keep going with the tapering plans means emerging markets will remain fragile. But to push back will give another green light to the hedge funds to go nuts on the speculation front.

--Softly is the best they can do. After all, it's Ben Bernanke's last meeting before he heads back off to the Ivory Towers of academia. He's not going to change course now. He's thinking of his legacy...

--In a year or two, when the system is imploding, someone will ask him what went wrong. (By this time the Fed will be universally scorned.) And he'll be able to answer...somewhat truthfully:

'I have no idea. When I left the place we were in the process of getting interest rates back to normal. The economy was improving and employment was growing. It must have been Janet, I knew she'd screw things up as soon as I left. Go and ask her.'

--And then that same someone will go and track Janet down. They'll find her in a nondescript town, trying to forget. She'll stare into the distance, muttering 'unintended consequences' over and over.

--It's as good an answer as any. Why did the world blow up...again? 'Unintended consequences'. Exactly.

--You see, this next stage of the crisis, which is surely coming, is not about the Fed's tapering. It's about the Fed's QE policy that preceded it. When you manage the world's reserve currency, you have an obligation to manage it in the best interests of the world, not just for domestic economic purposes.

--The Fed, with a focus on domestic employment, ran monetary policy for the US and the US only. But the liquidity they created post 2008 leaked into the rest of the world and set-off booms in emerging markets, notably in China.

--Now, liquidity and capital is flowing the other way. It's coming back out of emerging markets, sending currencies crashing and interest rates soaring. But it's early days. This emerging markets crisis looks like it's just warming up.

--Check out what's going on in Turkey. In an attempt to slow foreign capital outflows, which is hurting the Turkish lira and sending market interest rates higher, Turkey's central bank has just increased its overnight lending rate to 12%...from 7.75%!

--That's quite a hike. While it will restore some confidence in the currency and help to keep inflation under control (estimated to be around 6.6% at year-end) it will bring about an economic slowdown.

--Now if you multiply this scenario across the emerging market economies, you have to expect a decent economic slowdown to take place over the first half of 2014. Not that all economies are going to hike rates by as much as Turkey. But they are all suffering capital outflows to varying degrees, which represents a monetary tightening. Slower growth will follow.

--It might take a few more months, but eventually even developed country stock markets will realise that slower growth in the emerging markets bloc will impact the profits of the large multinationals. Their safe haven status may come under question.

--What, or where, is the safe haven in a world of tighter global liquidity? There doesn't seem to be one. 'Cheap assets' is the only answer we can come up with. But with seemingly every asset having inflated over the past five years, there's not a lot of cheapness around.

--In a report to subscribers at the end of last year, we ventured that commodities and gold were the cheapest assets around. We also guessed that they might become cheaper still should the emerging markets rout pick up pace. But at that point, adding some of these beaten up assets to your portfolio might make sense.

--Perhaps we should ask China about safe havens? In 2013, according to Reuters:

'China imported about 1,158.162 tonnes from Hong Kong, compared with 557.478 tonnes in 2012, overtaking India to become the world's biggest gold buyer.'

--Is it because of the credit boom that China is buying so much gold...or is it because of the fear of what comes after the boom?

--We don't know. It's probably a bit of both. Credit booms lead to an explosion in the money supply. In China, if you're a recipient of a large wad of new money you can either conspicuously consume it, put it into a bank or a wealth management product promising high (but risky) returns, or borrow against it to buy property.

--Or you can put a bit into a time tested 'safe haven', like gold. After all, the West is selling heavily so it's available at a good price. News of such robust Chinese demand is nothing new. They're simply soaking up what the West is selling. Gold is coming out of the vaults in London, being melted down and recast into smaller bars that fit the preferences of the Asian markets, and moving into China and elsewhere.

--The China demand story is important, but it's not necessarily the thing that will kick off a new bull market in precious metals. That will happen when the West regains its appetite for gold. Because at that point, the supply of gold will be severely constrained. China isn't giving any back. Not at these prices. It will require much higher prices to get the gold flowing again.

--So when will the West regain its appetite for gold, you ask? We don't know. Probably around the time when you hear Janet Yellen repeatedly muttering 'unintended consequences' through a thousand yard stare...

Regards,

Greg Canavan+
for The Daily Reckoning Australia

..............................................

And lastly:

The weekly setups of the Dow Jones seems to signal the end of this bull.

No matter whether 50 more points are added. Start to get rid of your stocks. You may still have a week of time for doing so.

Perhaps there will be another try to head for the current highs, even to exceed them in the short term. It will be possible during the coming few trading days yet.

But if the markets keep on slipping down, by the beginning of February this repeated approach will take place with a high volume for several months.

No later than that, lower lows on daily or weekly base should be the outcome!

Danger, get out of the stocks :

ALL IN M- H- O !