Eric Nuttall's Top Picks: May 31, 2023

Eric Nuttall, partner and senior portfolio manager, Ninepoint Partners

FOCUS: Energy stocks 

MARKET OUTLOOK:

Never before has the chasm between narrative and reality been so wide. As investors maniacally fret over a recession, countries like China and India month after month report record demand, airlines report record activity, and few data points worldwide give credence to the notion that the physical demand for oil is faltering.

Meanwhile, the OPEC voluntary cut is just taking hold, Russian exports appear to finally be beginning to roll over, U.S. shale spending discipline remains the new normal, and the supermajors prioritize decarbonization over production growth. We believe that even with a recession in Europe and the U.S., global oil inventories will fall at a record pace this summer, ending the year at a five to 10+ year low. It is mind-blowing to us that with such strong fundamentals that sentiment, as measured by net length in oil, is currently near the same level as in April 2020 when the world was experiencing the biggest demand shock in history.

With oil stocks discounting $55-$60/bbl and oil trading around US$70, balance sheets are in their strongest positions in perhaps history. Additionally, companies are generating record amounts of free cash flow, the current level of pessimism is completely unwarranted. We see sentiment bottoming in the next month and believe that oil can still rally to US$90-$100/bbl by the end of the year. We remain bullish.

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TOP PICKS

Cenovus Energy (CVE TSX)

Cenovus appears to be on the cusp of meaningful improvements in its downstream operations, something that has plagued the company for over a year (the new chief executive officer recently bought $1 million in stock personally while guiding for normalized operations in the coming months). With the company hitting its final debt target in the fourth quarter of this year and pledging to return 100 per cent of free cash flow back to investors thereafter, we believe the company could either pay a dividend (or buy back the equivalent) of 16-24 per cent at US$80/$100WTI. We believe fair value is 6X EV/CF = 74-130 per cent upside at US$80/$100WTI. 

Headwater Exploration (HWX TSX)

Headwater recently announced highly encouraging exploration success unlocking significant additional running room in the most economic play in North America, which if anyone still paid attention to well results should have negated any worries about limited drilling inventory. It is trading at a 6.4 per cent dividend yield, 3.8x/3.0x EV/CF at $80/$100, no debt, and essentially 100 per cent exposed to our bullish outlook for Western Canadian Select. We see the company having the ability to increase production by over 20 per cent while more than doubling the dividend over the next two years.

Whitecap Resources (WCP TSX)

Whitecap offers over 20 years of “stay flat” drilling inventory while trading at a 21/30 per cent free cash flow yield at US$80/$100WTI in 2024.  Soon hitting its final debt target, the company will bump its annual dividend to a 7.6 per cent effective yield yet have the ability to either double or triple it at US$80/$100WTI (or preferably allocate residual free cash flow towards share buybacks). Trading at a 3.0x/2.4x EV/CF at $80/$100 and able to privatize in three to five years at $80/$100, we believe we are getting at least $15 billion in future free cash flow for free.