A discussion about opportunities in the Canadian energy sector

Equity research analyst (energy) Jeremy McCrea, joins the podcast to discuss the Canadian energy sector, including:

• Intuitional views of the sector
• Recent piece 10 Red Flags to Watch Out For This Reserve Season and Alternative Solutions – maybe let us know what reserve season is and why it’s important.
• Top three red flags (full report been posted to our social media accounts).
• Record profits
• M&A activity

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Transcript

Chris Cooksey: Hello, and welcome to the Advantaged Investor, a Raymond James Limited podcast. A podcast that provides perspective for Canadian investors who wanna remain knowledgeable, informed, and focused on long-term success. We are recording this episode on February 14th, 2023. Happy Valentine's Day. I'm Chris Cooksey from the Raymond James Corporate Communications and Marketing Department, and today I'm looking forward to chatting with Jeremy McCrae.

Jeremy is an equity research analyst concentrating on energy, and today we'll be discussing what's going on in the energy sector. Jeremy, thanks for joining us. How are you doing today?

Jeremy McCrea: Yeah, I'm great. Thank you.

Chris Cooksey: Great. You know, it's always a lot to discuss when it comes to energy. It's maybe appropriate that we're doing this on Valentine's Day Canadians love our energy sector. So, let's just start off quickly with, maybe the smart money and how institutional, money views the sector right now.

Jeremy McCrea: Yeah. We've seen a lot of money start to come into the equity oil and gas here in the last few months, especially what we've really look at is the filings from the 13 Fs and alternative monthly filings.

And what you're seeing though now is much more larger generalist funds come into the sector. They've been effectively gone for the last several years, but really in the last, quarter when we can look at this data, you've seen them come into this sector. At, at record rates relative to anything we've seen in the past.

And it's, it's not just your specialty funds. These are your large pension funds that are coming back when the oil and gas sector was somewhat uninvestible even just a few years ago. There's a realization that oil and gas is going to be around for quite some time. We need to be involved in this sector.

Chris Cooksey: So these are more like your Canadian equity funds or whatever, rather than your energy specific funds type situation.

Jeremy McCrea: These are your broader base generalists type of funds who invest in tech and financials. And they're now saying, you know, we need to get up to at least equal weight. Okay. but it's more importantly too is we're actually seeing a lot of US and international investors come back into the sector looking at the flow of funds, numbers and it, I think they're looking at Canada saying, You know, you guys do actually have a lot of good ESG scores here.

You're very profitable, way more profitable than almost any other thing internationally, just given we had the benefit of the foreign exchange that's helping in our favour and we don't have the differential issue that we've, that's plagued this industry for the last several years here. So it's, it's a lot of positive marks where you look at these profitability for the sector and saying, we need to be involved.

and maybe a little safer.

Chris Cooksey: too in terms of what could go wrong compared to maybe the Middle East and Russia and that sort of stuff.

Jeremy McCrea: The Black Swan event is pervasive throughout this industry. That is the one thing that holds a lot of guys back saying there is, you never know what kind of event's going to hit the market here, where you just don't wanna be involved in this sector.

Mm-hmm. . So that keeps have and has kept guys away, but bit by bit, we've adjusted to handle those kind of situations here now.

Chris Cooksey: Perfect. Now, recently you put out a piece, 10 red flags to watch out for this reserve season and alternative solutions. So maybe just a quick overview of what reserve season is and why it's important to the industry.

Jeremy McCrea: Sure. So when I look at the oil and gas sector, a lot of guys come into the oil and gas sector saying, I think oil, I'm coming in to buy because I think oil's going higher or lower, or pick your, but trying to forecast where oil and gas prices are going to go is. It's almost a mugs game. It's such a complex system that you never really know what's going to go higher or lower.

So what we try and do is understand not so much where oil prices are going to go, but what's the perception of where that price is. But more importantly, who's doing something different on their land base that is going to justify a higher multiple? And as, as the market says, I should pay more for this undrilled acreage or pay a higher multiple because you have better growth.

And a lot of the times when you talk to the company or look at a presentation, you don't necessarily get that detail that you're looking for, but the reserves will provide that detail and then provide you a lot of clues in terms of who's doing something better or who's wells are deteriorating. And it can really give you a shift of, you know, oil prices may go down, but if I can find a company whose multiple is going to expand because they're, there's some nuances going on with the reserves, I can actually be neutral and if oil prices go the other way and go up, well now I get to double down with the multiple expansion and the benefit of the oil price. So that's why we use reserve season to really uncover a lot of clues. Oh, that makes sense.

Chris Cooksey: Maybe let's just highlight a couple of or, three of these, red flags.

And for listeners, we have shared this report on our social media, both LinkedIn and Twitter. Jeremy as well has shared it. So check it out, for the other seven that we don't get to. But, let's just talk maybe about three of them.

Jeremy McCrea: So the one, this is kind of bit of a personal favourite, is technical reserve revisions.

So this is really buried down on page 80 of the reserve report here. But what you're looking for here is, are the engineers revising type curves up or are they revising them down? And for the most part, when you drill a new, well, a company will come up with a standard type curve, and if the wells are coming in better, they'll revise those numbers up and if they're getting worse, they'll, they'll go down.

And that way you can get a sense. is this land base that this company has and all the future inventory, is it getting better or worse? Because that's a good reflection of what's going to happen for future growth and sustainable dividend ability and all the other things that kind of right. Come along with that.

But it all starts with the well results and if the reserves are getting better, that that's a precursor for everything else that's getting better here. The, the other thing is, is. Looking at what we call your F and D costs here as well too. And what you're really trying to look at here is. how are your F and D costs compared to other companies?

And so whoever can have the lowest F and D ultimately is, and what, what F and D stands for is your finding development costs. This is what you spend to get reserves in the ground, right? And a lot of times if you have a higher commodity price deck, , or if you're adding a lot more gas versus oil, it can provide a lot of nuances in terms of are you really profitable or are you just showing some good headline numbers that may be not as profitable?

So ultimately it can give you some clues in terms of who's, who's really the most profitable, versus just looking at financial statements that sometimes doesn't give you an indication of, what did I spend money on this year, and what is the. What did I actually get for those, the money I spent here versus a lot of the times we're looking at past decisions that were based 10 years ago, which don't really have any applicable, you know, foresight going forward.

And maybe just kind of the, the last thing that, you know, we always kind of look for is, this is on the leverage side of things and is what we call a debt to your proved developed producing reserve. So a lot of times guys look at things on a debt to EBITDA level, but in oil and gas, so much of your, cashflow declines at a pretty steep rate here.

And so what they found, like, and what we all found during COVID was, when you, when you, when you aren't drilling, your production can decline pretty quick. And so, it's better. If you look at things on a debt to reserve basis as opposed to a debt to cash flow basis. Okay? especially for the sector where the banks lend on a debt to prove reserve basis versus cash flow.

It gives you an indication of how willingness the banks are going to lend to you if, you know, push comes the shove. So those will be the three things. What's your debt to reserve basis? What's your technical revisions and how does your F and D cost look relative to other guys?

Chris Cooksey: Great. Now, I believe profits in the industry have been very strong, so maybe just touch on, on those right now.

Jeremy McCrea: Yeah. 2022 has had record profits across the board here. You know, it doesn't matter which country you're in, it has been absolutely phenomenal here and. , it's a realization, that it was not just the Russia war that caused these outsized profits. This has been in the works for the last several years here and since 2014 when oil prices collapsed back then, there's been a lack of capital that has gone into the sector, and part of it was the collapse of oil prices, but that transgressed into a realization with a lot of management teams that, you know, maybe we are transitioning to renewables pretty quick. We're all going to have electric vehicles here in five years, 10 years. And this perception that we're transitioning to renewables this quickly has said, you know what? Maybe we won't do new oil sense project.

Maybe we won't build this new pipeline or oil battery. We don't want to build something that's going to have a 10, 20 year life if oil and gas is not going to be here around in 10 to 20 years. So you really had a lack of capital that has gone into the sector over the last several years. And when the Russian War started, that really became more apparent of how little supply we really do now have on a global scale.

So the second part to this though is even though oil prices have jumped quite a bit, no oil and gas companies are really putting much more capital into the ground. They've seen their share prices perform well because they've given back these profits in the forms of dividends or buybacks, debt repayment, and they're saying, we still don't know how this re re renewable transition's going to play out here. Our stocker is doing well. Our shareholders just want dividends, so we're just going to continue to enjoy these high profits. Give that back. And ultimately, you're seeing more and more investors recognize that here, and that's why you're seeing these big pension funds now come back into the sector.

Chris Cooksey: That makes sense. Now, in terms of, usually when things start getting good, you start getting the, a bit of merger and ac acquisition activity. How, how has, M and A been, in this industry?

Jeremy McCrea: You know, it should have been higher here, and part of the reason why we haven't seen it as high was you've had the volatility in oil prices to the extreme that we've ever really seen here before. What you need for M and A to happen is some stabilization in oil prices. And now that we've been sitting around $80 here for a few months, I suspect you're going to see a big pickup every six months. We do a survey with every oil and gas CEO here in the sector, public and private.

We typically get about 60 surveys back from the CEOs, and one of the questions that we ask is how many companies are going to be sold or merged over the next six months? And this was a few months ago and you had, I'm going to get this number slightly wrong, but about 80% of CEOs say you're going to see at least, two or more mergers of companies in the TSX composite that are effectively going to merge here.

we haven't really seen anything here. So there's a lot of things going on behind the scenes. I think we were waiting for that stability of oil prices. And now that we have that, I suspect you're going to see some deals going forward here.

Chris Cooksey: People are ready to make the decision now that, things are stabilized, basically, as I just said.

Jeremy McCrea: That's right. Like the buyers want, the saying, look at, if you look at the current strip, you're looking at 75, $80. The sellers are saying, we were just at a hundred dollars not too long ago. And so that price difference is you can never get an agreement, but now that things have come closer, you're probably going to be able to see some, some deals here now.

Chris Cooksey: Alrighty. Is there anything else you'd like to leave the listeners with?

Jeremy McCrea: I think is the valuations that the sector still is seeing is some of the lowest we've ever really seen here. And it's just a realization. There's trepidation that our oil prices are going to collapse again. And when you look at where inflation is and your marginal cost to bring on a us play a well in the us, you, you're, you don't have that much bit of a room, wiggle room going down, like you're breaking evens now for us or probably looking around 65, $70 for your next marginal, well, we're in Canada.

Just given where our foreign exchange rate is here, Canadian operators are still seeing about a hundred dollars Canadian for theirs. And the profitability for Canada is, is holding in quite, quite strong. So, between the valuations, the, basically, essentially no debt now and this high profitability, this is the best this sector really has ever looked.

And I think that's why you're going to continue to see capital flow into the. .

Chris Cooksey: Awesome. Well, Jeremy, thank you very much for sharing your insights. I hope you'll join us again as things evolve in this industry. As I said, very important one for Canadian and guests, worldwide investors. So, hope you'll join us again, and thanks for joining us.

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