We welcome back contributing editor Ryan Irvine who revisits some of his energy-related picks in the context of the new reality in the sector. Ryan is the CEO of KeyStone Financial and one of the country’s top experts in small cap stocks. He lives in the Vancouver area. Here is his report.
Ryan Irvine writes:
This year, and more acutely over the past month, we have seen a sharp uptick in a select number of the energy related stocks from our coverage universe from the lows experienced after the oil price shock which began this past fall.
As oil prices have shown strength in recent weeks, investors have bid up what we consider the more quality (profitable) energy shares, including Parex Resources Inc., which has seen its shares gain over 50%, from the January lows. Shares in Macro Enterprises Inc. have more than doubled since dropping to 52-week lows in January of this year. Some of the gains are deserved as the price declines are typically overdone as panic sets in. However, we do see some risk in the segment as capital spending has ground to a halt near-term. Crude is now well above its lows but still remains 35% lower than the levels we saw at this time last year and by most reports, the world remains awash in the stuff at the moment.
Given this widely held view, it is unclear as to whether a continued uptick in oil is sustainable. At the very least, the rally appears somewhat fragile. What we do know is that capital spending will be significantly lower in the energy segment for at least 12 months. As such, we are not looking to add to our exposure in this group and will take the opportunity to cut some names following the recent uptick.
We stress that nearly all of these companies will be facing significantly lower year-over-year results for the next 12-18 months at a minimum. As a result, we are cutting ratings on Macro and Parex – details and specific recommendations on each are provided in my updates.
For example, in the case of Parex, we continue to see the stock as the best of the Canadian-listed international oil producers. However, given the recent gains in the share price, we view the stock as fair to moderately richly valued at present. Of course, if oil continues to move higher, these stocks will perform well. We just do not feel it is necessary to be overexposed to this volatile segment at present. For unique exposure to the segment we continue to recommend High Arctic Energy Services, which pays a healthy dividend and is well positioned to post strong cash flow in 2015 when most in the segment will face significant declines.
Macro Enterprises Inc. (TSXV:MCR, Financial) (OTC:MCESF)
Originally recommended on June 2/13 (#21320) at C$3.63, US$3.62. Closed Friday at C$2.50, US$2.45 (May 4).
Background: Headquartered in Fort St. John B.C., Macro’s core business is providing pipeline and facilities construction and maintenance services to major companies in the oil and gas industry in Northeastern B.C. and Northwestern Alberta.
Outlook: As a result of the significant decline that commodity prices experienced during the second half of 2014 and through the start of 2015, activity levels in the oil and gas industry have been materially impacted across Western Canada. Although the pricing uncertainty is affecting activity and many projects have been delayed, Macro reported that large oil and gas companies are continuing to request bids on significant projects, both LNG (liquefied natural gas) related and not. With a solid balance sheet, the company is positioned to weather these uncertain times.
Management is anticipating revenues in the first half of fiscal 2015 to be significantly less than those recorded in the same period last year, which were a record at the time. Rather, it is looking for revenue that is more closely aligned with what was recognized in the second half of the prior year. The company is targeting margins more in line with historical averages and as such expects to see financial improvements to its operations throughout the upcoming year.
Growth wildcard: As part of its strategy, the company is seeking construction contracts in connection with the LNG projects being planned on the west coast of British Columbia. This is an industry that is anticipated to bring substantial economic activity to B.C. over the next 30 years. Macro has completed bid processes and has entered into discussions with the LNG project owners regarding future pipeline and facilities construction.
Macro has also been approached by several major clients to assist with budget and constructability estimates for major pipeline and facility projects that are not LNG related. These projects are scheduled for approvals by mid to late 2015.
Conclusion: Macro’s shares have more than doubled since its oil price driven lows hit earlier in the year, when it bottomed out at $1.17 on Jan. 30. While we believe the company is well positioned to benefit from infrastructure and LNG work if and when new projects come online, the current environment will produce year-over-year declines in revenues throughout 2015. While management has stated that it expects margins to be closer to historical averages in 2015, there is a danger that the low price environment increases competition and makes the company even more of a risk taker, particularly over the next year.
Macro has a strong balance sheet and its CEO known as a first-rate operator in a tough business, so the company will survive this downturn. The firm has idle equipment ready for larger scale work and at present is essentially a “lottery ticket” on higher energy prices and the long-term development of West Coast LNG.
For those that like this type of investing, the company offers value at this stage, but we prefer more consistent and predictable cash flow that is less dependent on a very volatile commodity. In the case of Macro, given the current environment, we have a great deal of difficultly realistically modeling cash flow over the next 12-18 months. Ultimately, the company’s fortunes will be tied to higher energy prices. If oil and gas continue to move up and sustain pricing, the lottery ticket will have a far greater chance of paying off and the rewards could be strong, but it’s all very unpredictable in the current environment.
Bearing all these factors in mind, we advise using the recent share price rise as a chance to divest our position in Macro and focus on less volatile companies to profit from a rise in energy prices.
Action now: Sell.
Parex Resources Inc. (TSX:PXT, Financial) (PARXF, Financial)
Originally recommended on July 28/13 (#21328) at C$5.38, US$5.23. Closed Friday at C$9.65, US$8.23 (May 6).
We introduced to Parex Resources Inc. to IWB members in July 2013 at $5.38. In May last year, with the stock trading in $11.50 range, we recommended readers sell half of their original positions in this Colombia light oil producer for a gain of 114%.
Background: Headquartered in Calgary, Parex is engaged in oil and natural gas exploration, development and production in South America and the Caribbean region.
Outlook: Parex has continued an impressive and positive multi-year track record of year-over-year growth in reserves and cash flow. The company continued to build on this in 2014. While we expect reserves to once again grow in 2015, cash flow will not in the current oil price environment.
When we first recommended Parex, the company traded at a significant discount to its peers on a cash flow and net asset value basis. Today, Parex has developed into a company with one of the best combinations of management, assets, and balance sheet strength in the Canadian national and international exploration and production segment, with an impressive track record of value creation through acquisitions and the drill bit. We expect Parex to maintain balance sheet strength relative to its peers in a reduced oil price environment, positioning itself to restart growth with opportunistic acquisitions or development of significant existing organic projects when oil prices recover.
Having said this, the company no longer trades at a discount to its peers given the relative strength of its shares in a dismal market. From a valuation basis, Parex’s 2015 expected EV/DACF (enterprise value to discounted annual cash flow) is currently 6.2 versus international peers at 4.4. The company trades at around 7.5 times the current year’s cash flow estimate versus 2.8 times when we originally recommended the stock. A good deal of the multiple expansions has come as a result of the drop in crude prices and would be resolved to a degree with oil returning to the US$80-$90 range.
Growth potential: Potential catalysts include results from exploration and appraisal/development drilling that have now restarted following a short hiatus at the beginning of this year.
Conclusion: Following the stock’s outperformance recently, we now view Parex as trading at a significant premium to a majority of its closest peers on net asset value metrics. Therefore, we are downgrading our rating to Sell near term and placing the company on our monitor list. We continue to see Parex as one of the best international junior oil producers, but its shares are not fundamentally inexpensive at this time.
Action now: Sell.
High Arctic Energy Services Inc. (TSX: HWO)(HGHAF, Financial)
Originally recommended on Sept. 2/13 (#21332) at C$2.85, US$2.55. Closed Friday at C$4.25, US$3.53.
Background: High Arctic is an international oil and gas services company with operations in both Papua New Guinea (PNG) and Western Canada. High Arctic’s substantial operation in Papua New Guinea is comprised of contract drilling, specialized well completion services and a rentals business, which includes rig matting, camps, and drilling support equipment.
Results: High Arctic reported strong performance for the fourth quarter and full year of 2014 with growth in earnings and EBITDA and continued accumulation of cash on the balance sheet.
The company reports that while the sharp decline in oil prices in the fourth quarter of 2014 has significantly reduced oil field activities in most regions of the world, High Arctic’s operation in PNG has not felt the effects of these declines as operators in PNG continue to focus on LNG development.
Outlook: Looking forward into 2015, the outlook appears to be solid with the company’s recently acquired drill rigs (Rig 115 and 116) scheduled to commence operation in the second and third quarters, both under two-year contract agreements. However, as High Arctic’s new drill rig acquisitions won’t fully begin to contribute to earnings until the latter half of the year, we may see a moderate decline in earnings and EBITDA in the first half of 2015 due to expected weakness in the Western Canadian operations and lower utilization in the rental business in PNG.
For the full year of 2015, we expect earnings and EBITDA to be flat to moderately ahead of the 2014 performance with growth in 2016. Relative to the peer group of energy service companies, High Arctic is extremely well positioned in the current market with a stable earnings profile, very solid balance sheet with $0.66 per share in net cash (and growing), and an attractive valuation.
Although we are generally advising investors to keep a minimal to moderate level of exposure in oil and gas producers and services companies, we continue to see significant upside in High Arctic over the next one to three years and view the stock as generally superior to its peer group and a solid growth and income investment in the energy sector.
Action now: Buy.
Hammond Power Solutions Inc. (TSX:HPS.A)(HMDPF)
Originally recommended on Jan. 28/13 (#21304) at C$8.60, US$8.58. Closed Friday at C$6.75, US$5.58.
Finally, we take a quick look at Hammond Power Solutions Inc., originally recommended in January 2013 when the stock traded at $8.32. The stock has been a laggard in our portfolio, closing this past week at $6.75.
Background: Hammond Power is a North American leader in the design and manufacture of dry-type custom electrical engineered magnetics, electrical dry-type, and cast resin transformers. Leading edge engineering capabilities, high quality products, and responsive service to customers’ needs have all served to establish HPS as a technical and innovative leader in the electrical and electronic industries.
Growth potential: Over the past five years, Hammond Power has invested in a number of growth initiatives including international acquisitions, capacity expansion strategies, new product development, and increased capital spending for strategic projects – all in anticipation of a sustained recovery and growth in its primary markets.
Conclusion: To date, this hoped-for sustained recovery has yet to gain real traction. The negative impact of an erratic and unpredictable economy as well as the variability of foreign currency exchange rates, manufacturing throughput, raw material commodity costs, and market pricing pressures has affected the company.
To a large degree, the company’s capacity has been too large for the amount of business the market is generating. As a result of the lack of throughput, its factories have not operated nearly as efficiently as the company had anticipated and margins have suffered.
We do expect that as the market recovers, Hammond Power will gain the throughput necessary to push margins, but the near-term outlook remains muddied. The business is a good one and not going anywhere. We maintain our Hold rating on the stock, potentially upgrading Hammond when we see a sustainable uptick in business.
The company has entered a new market, which may enhance profitability by year’s end. We will monitor this closely.
Action now: Hold.
- end Ryan Irvine
