Mainstream investors had shunned oil and gas stocks during its six-year bear market. Now they are poised to return
Deeply oversold stocks get a second look
CALGARY — There are early signs that generalist institutional investors are returning to the oil and gas sector, though some in the business question whether an investor influx will hurt returns.
Oil and gas exploration and production equities are expected to be among the most in-demand stocks over the next three months, according to a recent poll of institutional shareholders by Toronto-based Brendan Wood International, which regularly polls 2,000 global institutional investors managing over $51 trillion.
The firm’s most recent survey on Aug. 24 showed forestry products, followed by oil and gas exploration, were the top two stock categories investors planned to buy in the coming months, in what investors, oil executives and analysts say could signal a return of generalist investors to the energy industry after a years-long sell off.
“There are so many investment professionals out there performing analysis on energy companies, our role is to quantify the resultant investor demand for the stock and why,” said Jordan Novak, partner with Brendan Wood International.
“After all the fundamental analysis on a company, the investor is still sitting in front of the screen with a buy, hold or sell option. A final factor, namely the strength of demand, often tips investor commitment to own a company,” Novak said.
The firm’s survey showed that 10 per cent more institutional shareholders planned to buy into the oil and gas exploration sector over the next 90 days. Notably, the survey respondents indicated they were also planning to sell off integrated oil and gas companies over the same period.
Brendan Wood International includes four Canadian names among the top 10 most in-demand exploration and production companies: ARC Resources Ltd., Parex Resources Inc., PrairieSky Royalty Ltd. and Tourmaline Oil Corp.
Some of the smaller names in the sector are also generating generalist investor interest after years in which those investors shunned the oil and gas sector for other lower emissions industries, including renewable utilities and the tech sector.
“It’s nowhere near where you would expect given the superior financial performance of these companies,” said Brian Schmidt, president and CEO of Calgary-based Tamarack Valley Energy Ltd., adding that some generalist investors have bought back into his company’s stock in recent equity raises.
The volume of oil and gas shares traded on the Toronto Stock Exchange fell from a peak of just over 19 billion in 2016 to 14.4 billion on average over the next three years, before picking up again to 18.9 billion last year as rock-bottom prices provided an opportunity for investors, TMX Group data shows. The number of trades had also fallen to a 10-year low of 31.56 million in 2017, compared to a peak of 48.2 million in 2014.
The annual value of shares traded, which easily averaged more than $200 billion in the first half of the decade, had plunged to $159 billion in 2020. The S&P Capped Energy Index has jumped 39 per cent year-to-date, nearly twice the growth of the main composite index.
But the first half of 2021 has seen strong trading in oil and gas stocks, with more than 9.5 billion shares traded during the period, and value of shares traded exceeding $111 billion. The number of trades, however, remain below the 10-year trend, suggesting many mainstream investors continue to sit on the sidelines.
Schmidt said he believes generalists will come back when companies can demonstrate they have a clean balance sheet and an ability to generate a lot of cash that will be paid out either in the form of dividends or share buybacks.
“I think next year, we’re going to be about $500 million in cash flow and it’s only going to take about $180 million to keep production flat,” Schmidt said, adding that he’s signalling to investors that the company could implement a dividend beginning in 2022.
Tamarack Valley shares are up 94 per cent so far this year to $2.44 per share on the Toronto Stock Exchange.
Schmidt said, though, there is a downside to a large number of investors piling back into the oil and gas industry.
“What exactly is in our best interest?” Schmidt asked, adding that a massive influx of generalist investors into the sector may be good for equity prices but could inflate asset prices, inflate costs and reduce returns. “What happens, when equity gets pounded in here, is then the returns go down. Guys start paying too much for stuff. I have never seen the kinds of returns and potential that I see right now in this sector.”
Interest from generalist investors may not be necessary for a longer-term rally in energy stocks, said Eric Nuttall, senior portfolio manager at NinePoint Partners in Toronto, who now runs the largest energy-focused fund in the country.
If energy companies commit to utilizing their own cash flows to buying back their stock, and retail investors continue buying into the sector, Nuttall believes the energy sector can continue to rally even without the mainstream investors piling back into oil and gas stocks.
“The average free cash flow yield right now is 34 per cent. Commit at least half to return of capital,” Nuttall said, adding that he’s urging energy companies to either buy back their own shares or boost dividends to the point where returns are “meaningful enough and bold enough to wake (generalists) from their comma and their apathy.”
He said that oil companies have returned capital this year to creditors in the form of aggressively paying down debt. He expects the major theme for 2022 in the energy sector will be return of capital to shareholders.
“The opportunity cost of not being involved in this sector needs to be high,” he said.
The Brendan Wood International report, as well as purchases by mutual funds, could be an early indication that generalist investors are beginning to buy into the sector ahead of dividend increases and larger share re-purchases, said Jeremy McCrea, director of oil and gas equity research at Raymond James.