Off the back of a global energy crisis, the energy sector had a phenomenal year in 2022. But things have certainly changed in 2023. With economic indicators all pointing to slowing inflation coupled with the impending recession that never seems to arrive, energy has become the market punching bag. Investors have moved away from economically sensitive sectors, and the spotlight now narrowly focuses on big tech and AI.

While energy equities have languished this year, we think now is the time, more than ever, to pick and choose what to own within the energy value chain. As the famous sell-side saying goes, "long-term bullish but expecting a pullback" is an apt way of describing where we are in the cycle. Still, this also doesn't mean we should sit with our hands tied while macros and short-term fundamentals roll us over. There are plenty of opportunities where we can pick up uncorrelated risk-adjusted returns in the short to medium term while we leave enough dry powder to capitalize on more juicy opportunities when valuations really start diverging from fundamentals.

So, in that spirit, let's delve into some of the key reasons why we think we are more likely to see $60 oil than $100, our diversified approach in minimizing correlation across our positions while capitalizing on opportunities across the energy value chain, and some of the key energy positions that look favourable.

Key takeaways:

• There is some uncertainty surrounding global oil demand, considering factors such as higher interest rates, a manufacturing recession, and the potential weakening of the global macro demand picture.
• The supply side is seen as having a surplus of oil, with Saudi Arabia making policy cuts to maintain a desired price range, while other countries like Iran, Venezuela, Nigeria, and Guyana have increased production.
• Despite geopolitical tensions and sanctions, Russian oil production and exports have remained steady.
• While there are challenges in the oil market, there are still areas within the energy value chain that offer attractive risk-adjusted returns, including the Canadian oil sands companies with low decline rates, retail fuel stations that remain resilient in terms of consumer spending, and early-stage exploration companies.

The global oil supply picture is worrying

While there are potential green shoots on the oil demand side in the back half of 2023 with the resiliency of North American consumer spending as well as stabilizing Chinese economy, the reality is the global oil demand picture is highly uncertain, given the confluence of macro factors including higher interest rates around the world coupled with the manufacturing recession that is already taking place. However, we do have a clearer picture of what supply looks like, and we get the sense that there is a lot of oil sloshing around in light of uncertain demand. We've distilled some key factors investors should consider when evaluating the supply-demand picture.

Saudi Arabia supply cut in context

While markets generally welcome any news of Saudi Arabia cutting production, we think the various policy cuts, voluntary cuts, and gaming the baselines since last year smells of desperation, with Saudi Arabia effectively going at it alone to keep a $70/$90 collar. At the targeted 9 Mbpd (million barrels per day) production level, the revenue is already unsustainable, given Mohammed bin Salman's budget goals. So, if the global macro demand picture really weakens, there are limited players that can pull supply as quickly in the short term. Between September 2022 through May this year, we've seen a headline OPEC+ cut of 3.7 Mbpd (2Mbpd in October 2022 and ~1.7 Mbpd from voluntary cuts), but the actual net cut we've seen is closer to ~500 Kbpd (thousand barrels per day) after factoring in increased productions from sanctioned countries and below-quota producers who are offsetting much of the baseline cuts.

Watch out for the "Silent 4"

One of my most highly regarded oil macro analysts at Capital One aptly coined the term "Silent 4," which refers to Iran, Venezuela, Nigeria, and Guyana. These countries have drastically upped their production in recent years without much press. Still, Iran alone has increased production year-over-year by 700 Kbpd, with the other three all increasing to the tune of 100 - 200 kbpd. Guyana – the country with the largest oil exploration field today that continues to surpass expectations – is especially interesting as they already came out and said they are not interested in joining OPEC.

A Russian production cut is… unlikely

Oil bulls have often pointed to dwindling Russian productions post the Ukraine invasion, whether it's the EU crude/product sanctions or lack of Western technology for producing crude and refined products. The reality is that Russian barrels continue to flow, and we're seeing export levels of crude, condensate, and refined products at the 6.5 Mbpd mark, comparable to pre-war levels. Some of the key reasons why Russia has kept up with production and exports are because 1) oil fields in Russia are not as technically complex versus your typical run-of-the-mill Permian wells, 2) Russian refineries are not as complex as North American refineries and therefore require less specialized equipment and catalysts to maintain operations, and 3) there are re-emerging investments in newer tanker fleets now that ship owners know the Russian oil trade is here to stay – the shortage in tankers seen last year was due to bringing back ships from the dead to get all the oil out.

Generating alpha in an uncertain oil environment

Despite the challenging backdrop of oil supply and demand, there remain many areas within the energy value chain that offer superior risk-adjusted returns that might be overlooked by investors today, given the majority of the energy headlines have centred around oil macros and speculation on how the impending recession will impact oil demand.

Inventory is king

While we are not as bullish as some of our peers on the short-term direction of oil, this also does not mean all oil names are created equal. In particular, there's been a divergence of multiples on companies in the E&P space, where the more years of reserve life you have, the higher multiples your companies will trade at. Productivity on a per-well basis has slowly trended down in the Permian as wells are getting harder to drill. For this reason, we are still highly constructive on Canadian oil sands, where companies have decades of inventories at very low decline versus their light oil peers and do not have to be on a constant treadmill just to keep their production flat. We also like the defensive nature of oil sands economics given the egress picture has significantly improved recently and the Trans Mountain Expansion pipeline that is due to start in 2024, which all leads to tighter discount pricing to the WTI benchmark. We continue to remain bullish on Athabasca Oil (ATH) and MEG Energy (MEG).

Resiliency in retail downstream

One area we particularly like within energy is the retail segment, i.e. gas stations. Despite the risks of consumer demand dropping off if a full recession was to hit, in reality, retail fuel margin has remained resilient as consumers tend to prioritize mobility spending more than other durables spending (as previously mentioned in What Can the Gas Pump Tell Us About the Economy?) . Convenience stores also offer additional diversification to the business, given that the majority of the products sold are consumed within hours and less impacted by the broader business cycles. The synergies between gas stations and convenience stores are only going up as the electric vehicle transition takes place. With today's battery tech, the average charging time for an EV is still much longer than filling up the tank, so what this means is more propensity for a consumer to spend at the convenience store while they're waiting for their cars to charge.

One company we particularly like is Alimentation Couche-Tard (ATD). ATD is a multinational convenience store company with a strong presence in Canada, Europe, and the US. With over 9,000 convenience stores in North America, including 8,000 offering road transport fuels, ATD is recognized as Circle K in the US. Fuel sales contribute 46% to the company's gross profit, with approximately 35 million gallons sold daily. Also, the company sells about 500,000 hot dogs per day. In today's market, ATD and other larger players like Murphy USA and Casey's General Store benefit from economies of scale, allowing them to maintain competitive prices compared with smaller retailers. These retailers can deliver consistent and rising margins by streamlining operational costs, including energy, labour, and credit card fees. This cost efficiency is particularly valuable in the face of fluctuating crude oil prices. ATD's business model has proven resilient, with consumers visiting stores more frequently for smaller purchases. This trend aligns with broader industry observations. As crude oil prices decrease, we anticipate even further expansion of margins for companies like ATD, reinforcing their position in a highly competitive market.

Uncorrelated returns in early-stage exploration companies (E&Ps)

One of the challenges running an energy mandate is that many of the names will ultimately trade with a high degree of correlation to the underlying commodity with different degrees of beta depending on leverage and asset economics, so from a diversification standpoint, it doesn't really make as much sense to own ten different Permian E&Ps where each incremental name adds little in improving the risk-adjusted return of the portfolio. This especially rings true in an environment where we don't see E&Ps as being grossly mispriced, and much of the short-term returns are driven purely by commodity pricing. In order to address the diversification challenge, we would argue that holding a basket of early-stage exploration companies can serve well to reduce the correlation of the portfolio given that it has its own idiosyncratic risk-reward characteristics as opposed to purely driven by commodity pricing. We are by no means saying early-stage companies are less risky, but if we do the work and believe these companies offer superior risk-adjusted returns at the standalone level, then it can serve to reduce overall portfolio volatility in the long run.

TAG Oil Ltd. (TAO) is a small-cap international oil company developing assets in Egypt. TAG was awarded the Abu Roash Formation (ARF) play within a producing field that Shell previously held and currently produces around 3,500 b/d by WEPCO (state operator) in a lower horizon. ARF is similar to Eagleford; however, it exhibits better reservoir properties. The reserve evaluators have given the company an NPV of C$450 MM based on the first 20 well development. There are an estimated 100 wells of current inventory, so the long-term upside could be substantial if the company can continue to convert resources to reserves.

The bottom line

There’s no question that energy equities have had a rough year. Still, as you can see, there are plenty of opportunities to capitalize on uncorrelated risk-adjusted returns in the short to medium term, like Canadian oil sands companies that have low decline rates, retail fuel stations that continue to show resilient consumer spending, and early-stage exploration companies that can add uncorrelated risk-reward like TAG Oil. The key is to consider a diversified approach in minimizing correlation across positions while capitalizing on opportunities across the energy value chain.

— Jeremy Lin is a Portfolio Manager at Purpose Investments

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