In this changing world, we take a closer look at Canada’s energy sector today—the ongoing themes and emerging opportunities. Franklin Bissett Investment Management’s Les Stelmach, Izabel Flis and Naveed Sunderji share their longer-term views and positive expectations.
Q: How would you describe the current energy investing landscape? Les Stelmach: It’s an interesting time. We’ve seen occasional reflexive selling, based on emerging demand or supply concerns, but they’ve been short-lived. Last November, consuming nations like the United States tried to mitigate higher crude oil prices by releasing volumes from strategic petroleum reserves to little avail. OPEC nations have considered refraining from bringing volumes back to market on fears of lower prices. Higher rates of COVID infection in some European countries, along with the emergence of the Omicron variant, sparked some sell-off in oil prices, but this appears to have been short-lived as the trajectory for global demand approaches pre-COVID levels.
In addition, the ongoing focus on climate change concerns, most recently articulated at the 2021 United Nations Climate Change Conference (COP26) in Glasgow, has increased pressure on producing nations and companies to limit production. The current lack of a coordinated suite of energy alternatives that can deliver reliably at the necessary scale does little to deter demand. Arguably, this phase of the transition is contributing to higher prices for crude oil and natural gas. Prices for both commodities have supported greater returns and profitability for oil and gas companies, rewarding investors willing to ignore the volatility.
We’ve seen a significant pickup in dividends since 2020.” - Les Stelmach
Q: From your vantage point, how do you see the shift in energy sources that’s underway?
Naveed Sunderji: Clearly, things are evolving and there’s a strong focus on increasing the use of renewable energy sources. However, right now the pace of growth of energy consumption is outpacing renewables’ growth. At this stage, such sources typically have lower capacity factors than hydrocarbons and over longer time periods generate comparatively less energy.
Izabel Flis: Renewables have shown some instability and aren’t at the point where they can be fully relied upon to generate the base load supply. For instance, during last summer’s heat wave, Californians experienced rolling blackouts as the state’s renewable energy capacity was unable to keep up with power demand. There’s currently a lot of either/or thinking about renewables and fossil fuels, where we believe both should be considered as complementary in a diversified basket of energy sources, at least until storage capabilities are further advanced.
Q: What does common ground for oil and gas companies and ESG look like?
Les Stelmach: For oil and gas companies, the emphasis on “E” (environmental) is really a “C” (climate change). In our view, the scrutiny around greenhouse gas emissions (GHG) should not isolate one measure to the exclusion of others. For instance, water and waste management, turnover rate, injury rates―these and many other factors are part of a comprehensive ESG analysis.
From an emissions perspective, Canada generally produces a high-standard barrel. Take a company such as longtime holding, ARC Resources Ltd. It’s rated triple-A with MSCI and our rating process. ARC has been a public company for over 25 years. Over the last five years (2016-2020), they have reduced emissions by 35% (not just by selling off high emission assets) while increasing production by 36%. Focusing on its northern British Columbia operations, for instance, the company negotiated with BC Hydro to electrify the area, replacing diesel/natural gas generators with zero emission hydroelectric power. From an innovation perspective, because fracking traditionally uses a lot of water, ARC has created a closed system to collect and reuse water. That’s one example.
Q: In the midst of ongoing challenges, how do you view pipelines?
Izabel Flis: New and existing pipelines are controversial. They also remain essential conduits for hydrocarbons. Demand and utilization are both robust, and not all infrastructure is valued equally; however, because no additional pipelines have been built and there’s no feasible alternative, all existing pipelines are valuable. They serve a diversified customer base, and those servicing natural gas exports are already supporting decarbonization efforts in developing nations.
Over the near future, we consider the longevity and cash flows for these assets to be stable. But that’s only part of the story. Looking longer term, we anticipate some pipelines may be converted to carry low-carbon renewable natural gas and hydrogen as these alternatives become more widely adopted, or as an option for sequestering carbon dioxide.
Q: What kind of shape are oil and gas companies in today?
Les Stelmach: After seven years of mostly hard times, we’re generally pleased with what we’re seeing. Free cash flows are significantly higher, and the excess is generally going to dividends, with some capital being raised. We’re also seeing some share buybacks. Debt repayment is the more consistent theme and companies aren’t relying on banks as much for financing. Although there’s more money to spend, labour shortages and limited capital expenditures are producing some constraints. As everyone knows, energy prices are influenced by inflation, and rising costs are keeping companies in line.
The Oilfield Services sector is generally part of any energy investment conversation. Typically, such companies would benefit significantly from higher commodity prices, as oil and gas producers would reinvest commodity windfalls into additional development drilling. As mentioned earlier, this cycle’s pattern has seen more producers refrain from significant budget increases, instead returning capital to shareholders through dividends or share buybacks. That’s starting to shift, as producers’ 2022 budget announcements include capital spending increases. This should translate favourably in the financial results of oilfield service companies in coming quarters.
Q: What impact is better news having on energy sector dividends?
Les Stelmach: We’ve seen a significant pickup in dividends since 2020. Companies are employing various dividend strategies, with some preferring methodical increases to the base dividend level at a rate sustainable under a range of commodity price scenarios. Others are considering variable dividends or periodic special dividend payments on top of the base dividend level. We believe boards and management teams are exercising a certain degree of caution to avoid being vulnerable if oil or gas prices experience a sharp decline. Should commodity prices hold near current levels, in our opinion, the outlook for ongoing dividend increases from numerous companies is good.
Q: Inflation is top of mind for many investors. Your thoughts on that concern?
Les Stelmach: Royalty producers have been long-term holdings in our dividend income strategy. Based on the structure, they receive a share of production from the well operator. Royalty producers aren’t responsible for operating costs or capital expenditures and, as a result, can benefit in a rising inflation environment. Holdings such as Topaz Energy Corp. and Freehold Royalties Ltd. come to mind. PrairieSky Royalty Ltd. is another excellent company.
Naveed Sunderji: If higher inflation continues into 2022, it’s worth noting that less interest-rate-sensitive sectors should outperform. Energy bonds are in this category, and we see them outperforming as higher commodity prices can better absorb inflationary shocks.
Q: What should investors be mindful of relative to investing in the energy sector in 2022?
Les Stelmach: Despite earnest commitments, the energy transition will take time. While factors such as divestment lobbying, increasing regulatory hurdles, protests, etc., are curbing oil and gas supplies, currently there’s not a similar concerted effort moderating demand. This emerging supply/demand imbalance implies sustained higher prices as we’re already seeing. Prospective financial returns look good. However, we believe investors should focus on energy producers who can succeed in reducing greenhouse gas emissions and their environmental footprint through innovation. The results include lowering costs, contributing to an improved environment, securing social licence to operate—all of which help ensure long-term success.