For some of you, the strong run up in crude oil and natural gas prices has provided welcome cash receipts from surface rights and mineral rights, a bright spot as producers struggle with a late harvest and the impact of BSE on cattle prices.
Oil is trading near record highs as a result of low inventories. Events in oil producing areas such as the Middle East and Nigeria and production delays associated with recent hurricanes in the United States have led to stronger prices. Natural gas prices have increased for several reasons:
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- Recent aggressive buying by utilities to lock up supply before winter.
- Concerns regarding a slow rebound in gas production from the Gulf of Mexico following a recent hurricane.
- Increased activity from speculators.
Does the recent surge in oil and gas prices represent an attractive opportunity for equities within this sector?
It is expected that the price of oil is likely to remain around $40 US per barrel and $6 per 1,000 cubic feet for gas into 2005. So what’s the best way to ride the surge in these commodity prices?
One way is to own shares of Canadian oil and gas production companies publicly traded on the Toronto Stock Exchange and the TSX Venture Exchange.
Oil and gas common stocks are outperforming the broader equity markets. As of Sept. 30, according to the CIBC Wood Gundy’s Index Return Monitor, the S&P/TSX Energy Index had returned 20.4 percent versus 5.4 percent for the S&P/TSX Composite Index year-to-date.
Irrespective of the performance of oil and gas common stocks to date, the rise in commodity prices does not appear to be fully reflected in most share prices.
When looking at valuation indicators such as price-to-earnings and price-to-cash flow, valuations within the energy sector appear to be cheaper than 2003 levels.
The Canadian oil and gas sector consists of stocks of various market capitalization, including junior, intermediate, senior and integrated exploration and production companies with operations around the world. Your adviser can direct you to specific companies.
Oil and gas royalty trusts have been an attractive asset class, outperforming equity benchmarks in the third quarter. As of Sept. 30, according to the CIBC Wood Gundy’s Index Return Monitor, the Energy Trust Total Return Index had returned 19.1 percent against the S&P/TSX Composite Index of 5.4 percent year-to-date.
Comprising about 28 issuers representing a market capitalization of $35 billion, this asset class is expected to grow as a result of further initial public offerings, public company conversions and equity issuance by existing royalty trusts to fund growth or acquisitions.
Oil-weighted royalty trusts are showing further upside given recent high oil prices. They appear to offer better value than gas-weighted royalty trusts. As well, we’ve seen resurgence in support from U.S. investors in trusts that are listed on both Canadian and U.S. exchanges. They are attracted by the strong oil price, strengthening Canadian dollar and falling yields on 10 year U.S. bonds.
When looking at a royalty trust, look for a strong reserve-life index (the higher the better), conservative payout ratios (the lower the better because retained cash flow is directed to build production and reserves), discounts to net asset value and rising distributions.
Canadian money managers have recently launched closed-end funds consisting exclusively of royalty trusts, which provide exposure to a diversified basket of royalty trusts. Listing is expected shortly on the TSX and forecasted yields have been reported in the 12 percent range with tax deferral attributes if held outside registered accounts.
If you prefer a passive way of investing in the sector, look at the five Canadian and U.S. Exchange Traded Funds, or ETFs. The TSX’s energy ETF, known as the S&P/TSX Capped Energy Index Fund, or iEnergy, has returned about 39.29 percent in the past 12 months, as of Sept. 30, according to Barclays Global Investors Canada.
There are also actively managed open-ended energy mutual funds, but remember that these investments have higher associated management fees and in some instances redemption charges to collapse out of the fund. However, if and when there is a pullback in commodity prices, this is not where you want to be.
I believe investors should maintain an overweighting to the oil and gas sector within the Canadian equity component of their portfolios.
We are in the midst of further expansion within the sector driven by strong cash flow generating ability, healthy balance sheets and the likelihood of further merger and acquisition activity. Valuations are attractive and crude oil and natural gas prices are the strongest that we have ever experienced.
Consult with your investment adviser to determine a suitable weighting based on your risk tolerance and investment objectives
Ian Morrison is an investment adviser with Wood Gundy in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. or The Western Producer. This column is for information only. Morrison can be reached at 800-332-1407 or by e-mail at Ian.Morrison@cibc.ca.
