Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement.
Despite having been pummelled over the past few years—or maybe because of it—resource stocks aren't getting much love these days. Yet oftentimes that is precisely when investors should be looking for bargains.
Take Calgary-based Birchcliff Energy, which produces natural gas in the Montney region that straddles the Alberta/British Columbia border. Even though Birchcliff's stock price has declined by half over the past two years, it's still trading near 100 times its trailing earnings per share over the past 12 months. Or ARC Resources, which is priced near 1,000 times its thin trailing earnings.
They sure don't look cheap. But forget traditional investing ratios, because there are other factors at play that those figures don't capture.
Savvy energy investors tend to put target prices on companies based on the value of their production and reserves. Obviously, oil and gas prices have a big impact on those values. It's hard to transport natural gas vast distances, so North American gas prices often vary by region. For Birchcliff, the key number is the so-called AECO reference price in Western Canada, which scraped along near $2 per gigajoule in early 2012, but climbed over $3 last fall.
Also remember that the price of gas doesn't affect the cost of producing it. This is where leverage comes in, and leverage is a powerful thing. Assume a company produces gas at a cost of $1.75, and sells it for $2. Let's also assume that the company is now earning 50 cents a share in profit per year. If its share price is $20, its price-to-earnings ratio (P/E) is 40. Sounds steep, right?
Not necessarily. Gas prices can move quickly, especially when they've been depressed for a long time. If gas prices climb to $3 in our example, revenue climbs by 50%, but the company's profit margin climbs by 400%. If the share price stays at $40, the P/E ratio plunges to a modest 16. And if the company has large reserves, the potential income stream from them also swells dramatically.
Will we see higher North American gas prices soon? Yes, because low prices tend to cure themselves. New drilling techniques in the early 2000s have produced a glut of gas, and the weak economy since 2008 has dampened demand. But now both supply and demand are reversing. A few years ago, 80% of North American drilling rigs were hunting for gas. Now that proportion is after crude.
What about the recent mini-boom in drilling for shale gas? Those unconventional wells tend to deplete much faster than traditional sources. Almost all of the increase in U.S. gas production over the past decade has come from unconventional sources. But reserves in those new wells are depleting by about 30% per year. With total U.S. gas production averaging about 65 billion cubic feet per day, the country needs to add about 20 bcf/day of new production each year just to stay even. That isn't likely to happen while four out of five drilling rigs are chasing oil.
Meanwhile, gas demand is slowly picking up steam. More vehicles are shifting to natural gas, as are power generators.
But the real elephant of demand will be the liquefied natural gas terminals that are being constructed on the West Coast to deliver gas to Asia. Gas prices in Asia are often more than five times higher than they are in North America.
Builders and operators of those terminals need to secure long-term supply. And where are they finding it? Much of it is in Montney and other still-robust conventional fields in Western Canada. The takeover mania has already started. Last year, Exxon agreed to buy Calgary's Celtic Exploration for $2.6 billion, and Malaysia's Petronas paid $6 billion for Progress Energy.
Those buyers understand the leverage that gas producers will soon enjoy. The best bets, according to people in the know? Birchcliff, ARC and Advantage Oil & Gas.
It's time for smart investors to start cooking with gas.
11.1 Forward price/earnings ratio
It looked like ShawCor shareholders had missed an opportunity. The Toronto-based pipe-coating concern put itself up for sale last fall, but gave up in December when no acceptable bid emerged. The share price slid to about $40. Then, controlling shareholder Virginia Shaw sold off the bulk of her multiple voting shares for $43. Now, with a low price/earnings ratio and a resurgence in the North American energy industry, the company looks like an attractive acquisition target.
Nordex Explosives Ltd.
23.9% Growth in revenue, first nine months of 2012
Pint-sized Nordex is in the business of blasting rock in mines, quarries and construction projects. The company is gaining market share in the mining camps of Northern Ontario with a proprietary bulk emulsion product that has more energy than dynamite sticks, but is easier to control. Revenue is growing by double digits, and Nordex has just raised $5 million. It's an earth-shattering opportunity.