The latest wisdom on energy

(July 28, 2005) The energy sector is on a tear and taking the entire Canadian market with it. The fundamentals supporting the boom are still relatively solid, but some analysts say we’re reaching cyclical highs, and managers are finding out shares are getting pretty fairly valued.

“None of the companies in the energy sphere — service, drilling, E&P (exploration and production) — are cheap. None of them,” says Benoit Gervais, investment analyst at Mackenzie Financial. “You’re paying full price for what you see today, so the game here in the third cycle will be who gets to grow; who gets to have more earnings.”

He says the bull market for the energy sector began back in 1999 with a range of company revaluations. At the time, the market priced companies based on oil price assumptions of between $18 and $22 a barrel. Following a pullback in 2002, a second cyclical bull market began, driven by higher prices. “We’re about to finish it now, we think,” he says. Going forward, the third market, he says will be driven by capital expenditures.

Unfortunately for motorists and growth fund managers who invest in companies that rely on consumers having disposable income, oil prices are expected to pull back, but remain near $50 a barrel going forward.

Eric Lascelles, economist at TD Bank Financial Group says 2004 was a big year for economic growth which in turn boosted demand for oil and natural gas. Historically, high inventory levels led to lower oil prices and vice versa. Although inventory levels are high, markets are pricing in a risk premium to reflect the uncertainty in major oil producing countries like Iraq and Russia. Beyond insolvency issues in Russia and Middle East instability, he says basic supply and demand concerns are underpinning the premium.

“Even beyond the threat of pipeline disruptions, the fear really seems to be that supply can’t grow all that quickly at present, whereas demand does seem to be trucking along with developing nations demanding more supplies and developed nations also asking for more,” he says. “We’re not at a point where demand exceeds supply, but it’s perceived to be a fairly close relationship right now and a little tighter than anyone would like.”

That said, managers, economists and even the Federal Reserve chairman, Alan Greenspan point out that there is a natural elasticity to demand and supply. “When energy prices are very high, people like you and I are less inclined to consume energy,” says Lascelles. “You hear about SUVs not being quite as popular as before. On the supply side, suddenly alternative energy sources are popular because they’re viable given that prices are as high as they are.”

In addition to solar power, wind energy and nuclear options, he points out that cleaner forms of coal energy emerge as viable options.

Money managers don’t sound worried about these latest trends, but some are beginning to trim their positions and reallocate assets to different parts of the sector. “We’ve been collectively reducing our exposure to energy. We’ve maintained a good weight for a number of years here, but we’ve probably been bigger sellers in the last quarter or so than we have been, really, since I can remember,” says Garey Aitken, vice president and director of equity research at Bissett Investment Management. “It’s really just a function of the valuations we’re seeing out there. We think there are more and more companies that are pretty fully valued here.”

Broadly, he says there isn’t any single sector that is being neglected as a result of energy sector dominance. Indeed, he says the Canadian markets been so strong that it can be difficult to find interesting investment ideas, but he says valuations still look attractive in the financial sector including banks and insurance companies.

On the energy side, Gervais says he is moving out of E&P companies and replacing them with service and drilling companies who will benefit from future capital expenditure improvements. “Be cycle aware, know where you are in the cycle and know when to take on risk versus lying off risk,” he says. “Within a long term bull market, we are closer to cyclical highs, so you want to lay off risk, not take on risk.”

Although average E&P earnings are being eaten by rising costs, he says select small cap exploration companies are also a good source of growth. Within the energy sector, he is also investing in thermal coal companies. “That’s part of this third cycle where we will bring new supply and alternatives. Humans will be clever about it,” he says. “People say, ‘well coal’s dirty’. We say it costs three times as much to product electricity from natural gas than from coal so why don’t you find a clean way to use coal and make a box of money. People are clever and they’re doing this.”

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com