Canada's energy sector: Back in vogue?

Bob Lyon's picture

It was a big week in Canada’s energy markets as Husky announced a hostile $3.3 billion bid for MEG Energy, the massive liquefied natural gas (LNG) export project, LNG Canada, received approval from project partners, and oil prices approach levels not seen since late 2014.


Husky vies for MEG Energy

Signature believes Husky’s offer for MEG Energy makes sense from all angles: MEG is a small-cap company with “big company” ambitions. It has high-quality SAGD[1] oil sands assets and strong operational capability, but has been hampered by too much debt and limited near-term cash flow to fund those ambitious growth plans. In addition, the variability in cash flow that comes with being an exclusive heavy oil producer was too much of a roller-coaster ride for MEG investors.

Husky, meanwhile, is a large-cap company with small and mid-company assets. In other words, it is in need of a large-scale asset with long reserve life and visible growth capability. Given Husky’s strong cash flow, almost bullet-proof balance sheet, and downstream capability to process and market heavy crude oil, it is one of a handful of companies that is well-placed to be a long-term winner in the oil sands.

Signature’s exposure to the deal is predominantly through exposure to MEG bonds (including holding the bonds in Signature Global Resource Fund). Coming out of the 2016 downturn, we believed MEG Energy bonds could have potentially superior performance over the long-term based on its attractive asset base with M&A upside. Despite MEG having an over-levered balance sheet at low oil prices, we felt this asset would fit well in a better capitalized and larger producer’s portfolio. Hence, it is one of our top holdings across the income funds.

We previously had a sizeable shareholding in Husky, but had recently exited the position due to the rise in Husky shares over the prior 12 months (up ~ 35%) and concern about the company possibly making an over-priced acquisition (see Chart 1 below). While we do not believe the initial offer for MEG is overpriced, the process has just begun and it would not surprise us to see MEG ultimately sold for a higher price – either to another bidder or to Husky itself. At this point it is a hostile bid, but it seems clear to us that MEG will not exist in its current form once this process plays out. The transaction, in whatever final form it takes, will further entrench the trend of consolidating large-scale oil sand assets into the hands of just a few large-cap Canadian oil companies.

Chart 1 – Husky Energy’s share price (HSE:CN) over last 12 months, as of October 1, 2018

Source: Bloomberg Finance L.P.

The bottom line is that this transaction makes sense for both parties. And it is yet another example of how the Signature team collaborates effectively across its fixed-income and equity team to maximize investment opportunities and outcomes across the entire suite of Signature funds.

LNG Canada

Canada’s first world-class scale LNG project received the green light from Royal Dutch Shell and its four partners (Korea Gas, PetroChina, Mitsubishi and Petronas), making it the first major new project for the fuel to gain approval in recent years. The key investment issue for Canadian energy investors is whether this will change the fortune of Canada’s long-suffering natural gas producers.

The combination of excess supply, a lack of new pipelines out of Canada, and a U.S. market that is increasingly served by its own rising natural gas production has meant that Canadian exports to the U.S. have declined in recent years and the price received for Canadian gas has plummeted. While this is good for consumers in Canada, it has been painful for our natural gas producers.

LNG Canada will provide some relief for Canadian gas producers, though it won’t solve Canada’s gas problem. Firstly, it will likely take up to five years to build, so any relief is unlikely to come until 2022 or 2023. Secondly, most of the partners in Canada LNG will be providing their own gas into the terminal, so the rest of Canada’s gas producers will not have any meaningful incremental volume pick-up. Thirdly, the initial volumes will likely not impact Canada’s gas market overall as gas production growth from liquid rich wells should balance that incremental demand. However, this could change when additional trains are added or when other LNG projects (such as Chevron’s Kitimat project) moves forward. This could change over time as the project ramps up to full capacity, but that can be up to a decade from now. Nonetheless, it is a positive, albeit a small one, for Canada’s gas market.

Outlook

At Signature, we are bullish on the oil market and have positioned our portfolios accordingly. We are overweight energy throughout our equity and balanced portfolios. Announcements like Husky’s bid for MEG Energy and approval of the LNG Canada project, along with a good supply-demand outlook for oil and cheap equity valuations, gives us even more confidence that we are on the right track with our bullish energy call.

Hoa Hong, Curtis Gillis and Carson Tong also contributed to this article.

 

IMPORTANT INFORMATION

Bob Lyon is the portfolio manager of some of the Signature funds. Hoa Hong is the portfolio manager of Signature Global Resource Fund and certain other Signature funds. Curtis Gillis is the portfolio manager of Signature Global Resource Fund and certain other Signature funds.

None of the authors has a material interest in the securities discussed herein; however, some are investors in certain Signature funds that hold these securities.

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[1] MEG Energy uses steam-assisted gravity drainage, or SAGD, technology to recover bitumen from the oil sands.

 

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