Toronto-the Huron Indian name for "place of meeting"-is a collision of new- and old-world architecture and cultures. The city is also the buyside capital of Canada, with most of that country's institutional-investor might clustered around Bay Street. Here, in this financial place of meeting, another collision is going on every day-between the investment bulls and bears-as to whether Canadian oil and gas equities represent a good place to park billions of dollars of capital. While no one investment thesis prevails, there seems to be clear consensus that there are selective buying opportunities within the sector and that, on a relative basis, oil and gas can be a safe harbor in times of choppy markets. Indeed, this April through June, the value of the overall common equity holdings of the top 50 Canadian investment funds declined 7.1%. In contrast, the value of their equity holdings in Canadian E&P stocks for the like period dipped only 1.2%. "Right now, the Toronto buyside appears very worried about a lot of other sectors of the Canadian economy, but much less so about energy," observes Martin P. Molyneaux, managing director, institutional research, FirstEnergy Capital Corp., Calgary. "One reason is that the transparency of earnings in the E&P group is very high versus other sectors. On a relative basis, top-line performance for an upstream company is easy to gauge-it's production volume times commodity price. Also, there's little mystery about how oil and gas income statements work. Investors like this sort of clarity." The analyst also points out that many Canadian producers recently reported second-quarter 2002 earnings results that beat market expectations. "In the case of Petro-Canada, it absolutely annihilated Bay Street with results way above expectations, in terms of earnings and cash-flow growth. As we continue to see more reporting like this during the next couple of quarters, buyside sentiment towards the sector should improve further." Molyneaux expects the Toronto Stock Exchange's oil and gas index should be able to deliver 20% to 25% returns during the next 12 months. This is based not only on the stock-price appreciation his firm has targeted for companies that comprise that index, but also on its 2003 commodity-price outlook: $23.50 for oil and $3.80 for gas. One leading Toronto buysider, Bob Lyon, vice president and portfolio manager for CI Mutual Funds, echoes Molyneaux's optimism. "The comfort level among institutional investors is slowly building that commodity prices can stay at higher levels for a lengthier period than we've seen in the past 15 to 20 years. In an environment where nothing else in the stock market is working, oil and gas stocks are beginning to look like a blue lagoon of tranquility in a stormy sea." TD Asset Management Sharing this commodity-price sentiment is Ari Levy, global energy analyst for TD Asset Management, Toronto. The money-management firm, which controls C$121 billion of assets-nearly C$33 billion of that in global equity portfolios-has a nearly 11% average weighting to oil and gas stocks throughout its funds. The budgets and social infrastructure costs of OPEC members are dictating higher prices for their oil, but not so high as to invite non-OPEC producers to make large investments to increase supply, he says. "We would thus expect a $20 to $22 oil-pricing band versus the cartel's historic $18 to $20 band. As for gas prices, they should remain $3 to $4. Above that, liquefied natural gas becomes competitive and industrial demand dampens." Levy, who helps manage the C$108-million TD Energy Fund and the C$118-million TD Resource Fund, is bullish on the Canadian integrateds, the emerging junior oils and the large-cap senior producers. The integrateds outperformed the S&P 500 by 10% to 20% in 2000, 2001 and first-half 2002, he notes. "Those we currently like and find inexpensive are Petro-Canada, Shell Canada and Suncor. Each has oil-sands leverage, double-digit annual production growth in front of it, management focused on cost containment and, in the case of Petro-Canada, an international leg of growth through its C$3-billion Veba Oil & Gas acquisition." Stresses Levy, "The oil-sands projects in which these companies are involved will allow Canada to be one of the few non-OPEC countries to grow oil production going forward." The analyst also likes some of the emerging junior oils, notably those led by seasoned management teams whose companies were bought out during the last big wave of Canadian upstream consolidation in 2001. They include Navigo Energy, Bow Valley Energy and Cequel Energy. "in each case, management is taking the company's current base of production and cash flow and using that as a platform to fund growth projects that will allow them to replicate their past successes." Bow Valley's management, for instance, is using the cash flow from its western Canadian production to fund nonoperated interests it has in drilling projects in the U.K. North Sea. Among large-cap Canadian E&P companies, Levy favors EnCana Corp.-the amalgam of Alberta Energy and PanCanadian Petroleum-now the largest producer in North America, even more so after its recent $350-million buy of Rockies gas assets from financially distressed The Williams Cos. "The new company has a strong gas profile, strong production-growth potential and significant gas-storage assets. It's quite a complete package." Beutel Goodman & Co. "I'm bearish, for the most part, on the Canadian oil and gas sector," says Toronto buysider Norman MacDonald, vice president, Canadian equities, Beutel Goodman & Co. "A lot of money has been spent on gas assets that will not translate into many companies earning their cost of capital, based on the price we see for that commodity on a normalized basis." With assets of about C$10 billion-$3.6 billion of that in Canadian equities-Beutel Goodman has an average 10.25% weighting to oil and gas stocks throughout its funds. MacDonald helps manage the Beutel Goodman Equity Fund, a C$135-million mutual fund. "While gas is trading higher than what the meltdown in U.S. industrial demand might suggest, oil is trading at an even higher war premium relative to its underlying fundamentals," says the buysider. "We would therefore be a little cautious on the Canadian E&P sector, playing it selectively from a discount-to-NAV (net asset value) perspective." Example: Talisman Energy. MacDonald latched onto that stock when it was trading well below his appraised $58-per-share NAV for the company. Another undervalued buy: Northstar Energy Ltd.-the Devon Energy arm in Canada-whose exchangeable shares (into Devon) still trade on the Toronto exchange. "Both companies are opportunity-rich and have strong managements-attributes that ultimately attract a premium share price to net asset value." MacDonald, however, is much more bullish about producers that generate high levels of free cash flow. "For this reason, we've always tended to maintain an overweight position in the integrated oils-Petro-Canada, Suncor and Husky Energy." Unlike E&P companies, which are saddled with rising finding and development (F&D) costs and ongoing capital commitments to replace short-lived reserves, these integrateds are heavily involved in long-lived, oil-sands projects that essentially have no F&D costs. "Very simply, they're dealing with oil-saturated sands at the surface-known deposits-whose reserve-life index is upwards of 35 years. We therefore tend to treat them more like manufacturing companies that are able to generate significant levels of free cash flow, which can then be used either to buy back stock or invest in other projects that earn returns well in excess of the cost of capital." Relative to their global peers, MacDonald sees a lot more opportunities for the Canadian integrateds-in terms of growth in production, cash flow and book value-simply because of the strategic value of these oil-sands projects. As for the Canadian junior oils, they've historically had more of a trading bias, with a lot of attendant stock-price volatility, he explains. "We're more of a bottom-up, longer-term, value manager of equities. So, with the exception of Western Oil Sands and Canadian Oil Sands Trust, there really isn't that much of a fit." MacDonald's take on the Maple Leaf oil-service sector? "Currently, the stocks in that sector aren't cheap enough for us to own, plus from a liquidity perspective, they're in most cases tough to trade." CM Investment Management Somewhat a kindred thinker is Gaelen Morphet, senior vice president of investments for CM Investment Management (formerly Merrill Lynch Investment Managers) in Toronto. "While the stocks of Canadian producers and service companies generally offer great trading opportunities for people who invest that way, we don't play that game; as a value investor, we're more favorably disposed to the Canadian integrated oils and royalty trusts." With C$2.3 billion of assets, CM Investment Management is a mutual fund manger with a 100% equity focus and an average 13% weighting in oil and gas stocks. Morphet comanages the firm's C$293-million Renaissance Core Value Fund and the C$576-million Renaissance Income Trust Fund. "The integrated oils during the past 20 years have averaged double-digit rates of return annually, and have consistently grown earnings and cash flow," she says. "By contrast, the E&P and service sectors are more boom-bust companies-they make money when commodity prices are good and lose money when they're not." Morphet, who sees oil prices moving lower during the next 12 months and Nymex gas hovering just under $3, says the beauty of integrateds like Petro-Canada, Imperial Oil and Shell Canada is superior land positions and long-term reserve and production-growth profiles. These are the result of their exposure to the huge oil-sands projects in northern Alberta, and oil and gas projects coming onstream offshore eastern Canada. "We expect their returns on equity to be in excess of 10% this year-in line with or higher than historical averages," she says. "Nonetheless, these stocks are trading at a discount, based on their normalized and projected returns on equity, price-book values and price-earnings ratios. And that's exactly what we look for in a stock-value with long-term growth potential." The portfolio manager is also sanguine about publicly traded Canadian oil and gas royalty trusts. During the past five years, they've managed better returns than the average Calgary E&P company, she contends. In addition, they have much lower cost structures, better balance sheets, greater acquisition discipline, much lower production-decline rates and higher reserve lives. "These royalty trusts are going to become more attractive to retail and institutional investors alike-in both Canada and the U.S.-because they offer better risk-adjusted returns than most upstream companies. Look for them to emerge as the midcap oil and gas companies in Canada, as the larger royalty trusts acquire the smaller, well-run ones." Morphet's favorite: Arc Energy Trust. It has an almost balanced asset base; a reserve life of 11.5 years; debt to total capitalization of 15%; a 79% payout, with the remaining 21% being directed to debt management and capital spending; and a monthly cash distribution that carries an annual yield of 12.3%. If one takes into account unit-price appreciation, Arc's total return-June 2001 through June 2002-was 27%. "Trusts like this in Canada are different from those in the U.S. because they're not depleting-asset vehicles-they have the capacity to grow," she stresses. Other oil and gas trusts she likes are Freehold Royalty Trust, which has an 11.9% annual yield, and Enerplus Energy Trust, which carries a 12.7% annual yield. CI Mutual Funds Neither bullish nor bearish, CI Mutual Funds' Bob Lyon exudes subdued optimism about Canadian producers' stocks. "There has been excellent absolute and relative outperformance by this group versus the broad market during the past three years, so a lot of the easy share gains are behind us. Having said that, we believe that there's still good underlying value in select oil and gas names, and that the longer-term outlook for the sector is brighter than it has been in some time." Managing about C$20 billion of assets-75% of that in Canadian and global equities-CI Mutual Funds has a 13% to 14% weighting in Canadian oil and gas stocks and an overall 7% to 8% exposure to global and domestic energy shares. Lyon manages the C$80-million CI Signature Canadian Resource Fund, the C$75-million CI Global Energy Fund and the small-cap C$200-million Signature Explorer Fund. His commodity-price outlook? "I used to consider myself a bull on gas prices, but lately I'm feeling more like a baby calf. If you look at the competing sources of energy-oil, coal, nuclear and imported liquefied natural gas (LNG)-they're going to keep the price of gas from getting much above $3.50 for any extended period of time." As for oil, OPEC has done a masterful job during the past couple of years managing prices in the low to mid-$20s, and they'll likely be able to hold prices in that range for a few more years, he says. "That's good news for producers in general, and for those operating the huge Canadian oil-sands projects in particular." Among Calgary's upstream seniors, Lyon likes Penn West Petroleum Ltd. "During the past five years, this balanced oil and gas producer has generated significant value for investors, tripling production, more than doubling its barrels of oil equivalent (BOE) per share and achieving an average 19% return on equity annually." Within the ranks of junior oils, he favors those operators that already have cheaply acquired assets-not producers currently looking to buy them in a frothy acquisitions market. Says Lyon, "There are huge amounts of cash floating around right now in Calgary, and the chance of buying a solid asset cheaply to build growth isn't that good." Among his top junior-oil picks is Navigo Energy. "The company has a new management team headed by Ron McIntosh, a former senior executive with Gulf Canada, Petro-Canada and Amerada Hess. Since taking over the once-troubled operator, he has sold off noncore assets, stabilized production, lowered costs and debt, and focused the producer's asset base in northern Alberta. This is the kind of company that's going to give shareholders the biggest bang for their buck, in terms of value creation." Like so many other Toronto buysiders, Lyon lionizes Petro-Canada. "With the arrival of Ron Brenneman as chief executive officer, the company has a renewed focus on the bottom line, plus it has the cheapest valuation in the group and a great inventory of growth assets." AIM Funds Management "There are individual opportunities within the Canadian oil and gas sector, but on a broad basis, our weighting to it is low simply because we're having a hard time finding attractively valued opportunities," says Keith Graham, vice president and portfolio manager for AIM Funds Management, Toronto. "That's because oil stocks continue to discount unsustainable $25-plus oil prices while gas stocks are still reflecting C$4 to C$5 Alberta Hub prices, even though those prices have recently dipped to C$2." With C$35 billion of mutual fund assets under management-upwards of C$12 billion of that in Canadian equities-AIM Funds Management is about 6% weighted to Maple Leaf oil and gas stocks. Graham runs the C$2-billion Trimark Income & Growth Fund and the C$330-million Trimark Canadian Small Companies Fund. His colleague, Rory Ronan, another portfolio manager, manages the C$90-million Trimark Canadian Resources Fund. "Even though we expect commodity prices long term to be lower than where they are today, we still like the prospects for Canadian producers relative to their U.S. peers," says Ronan. "Calgary's operators maintain conservative balance sheets. U.S. operators tend to be more aggressive, as we saw in the last round of M&A activity, when they stretched their balance sheets to pay very high prices for Canadian companies at the top of the market." Moreover, he adds, Canadian producers tend to be, on a relative basis, less richly valued than their U.S. counterparts-plus they have more growth opportunities, including the massive potential arising from oil-sands projects in western Canada. "What many people don't know is that there's more oil in the Canadian tar sands than there is in all of Saudi Arabia," says Graham. "That's why we have major equity stakes in Suncor and in Canadian Oil Sands Trust, which holds a 22% interest in the Syncrude oil-sands project." The buysider also likes Canadian producers that can grow profitably in international markets. Talisman Energy fits this bill plus, because of its controversial presence in Sudan, its shares have been penalized-making it one of the cheapest oil and gas stocks in Canada. "However, the company has indicated that it's about to sell its interests there, so we would expect its market valuation to improve." Two other international players Ronan lauds: EnCana Corp. and Nexen Inc. "The new EnCana is levered to oil and gas growth opportunities in Ecuador, the North Sea, offshore eastern Canada, the Gulf of Mexico and western Canada, and should be able to grow volumes 10% to 15% annually during the next three to four years," he says. "Nexen, meanwhile, has three huge generators of free cash flow: Yemen, its interest in Syncrude and its specialty chemicals business-hidden assets the market hasn't fully appreciated yet." Graham also sees selective opportunities in the junior-oil sector. "For years, Canadian 88 Energy overleveraged, overpromised and underdelivered-yet the Alberta-focused company has a good land base, good gas assets and infrastructure, and low royalty payments," he says. "Now the management team from Canadian Hunter has taken charge, and reserves have been written down significantly, assets have been sold off, and the balance sheet cleaned up." He adds that Progress Energy, now led by the former EnCal Energy management team, should be able to grow daily production from 5,000 BOE to 50,000 during the next five to 10 years. Ronan, meanwhile, cites attractive buys among the Canadian drillers. He notes that during the past five years, Ensign Resource Service Group has achieved an average annual return on equity in excess of 20%. Similarly, Precision Drilling has done a great job of creating shareholder value, and plans to grow internationally and through a new downhole- technology division. Yet, both stocks trade at low valuations. Altamira Management Jim Huang, assistant vice president and portfolio manager, Altamira Management, Toronto, says, "Not all of my colleagues agree with me, but I think we're entering a cyclical growth phase within a secular uptrend in the Canadian oil and gas sector that will continue for the next three to five years." With C$7 billion of managed assets-about C$5.25 billion of that in equities-Altamira Management has an average 13% weighting in oil and gas stocks across its 47 funds. Huang manages the C$50-million AltaFund, a general Canadian equity fund, and has input on other firm funds. The energy specialist is targeting $23 oil this year, dipping to $21 next year. "Given the annual growth in world oil demand-1- to 1.5-million barrels per day nominally-and the fact that non-OPEC production is only able to supply 700,00 to 800,000 barrels per day of that incremental growth, the cartel is in the best position to keep oil prices high enough to maintain its social system." As for gas, the buysider is eyeing an equilibrium Nymex price of $3.50. "That's what is needed to stimulate the production required to offset the steep decline rates-as much as 35% annually-now accelerating in all North American basins, without excessively punishing demand." Although Canadian oil and gas stocks have done well during the past few years, they're far from being fully valued, he says. "Based on our outlook for commodity prices, there's still a minimum 25% to 30% upside in all these stocks." Some of the large-cap Maple Leaf names Huang likes are Petro-Canada, Suncor, Canadian Natural Resources, Talisman Energy and Penn West Petroleum. Among the small-cap names, he favors Canadian 88 Energy, Baytex Energy, Progress Energy and Cequel Energy. And, among service companies, Ensign Resource Service Group, NQL Drilling and Pason Systems. "I try to buy into companies that are undervalued, but have good growth assets, conservative balance sheets and managements with a good track record," he says. "All these companies fit those criteria, in varying degrees." Huang points out that Petro-Canada-trading at 5.8 times its 2003 debt-adjusted cash flow versus a peer-group average multiple of 10-isn't being given credit for its accretive, bottom-of-the-cycle buy of Veba Oil & Gas, a German company with assets in the North Sea, Venezuela, Libya and Syria. Similarly, Canadian Natural Resources trades at an unreasonable discount because of its exposure to lower-netback heavy oil. "However, with light oil resources rapidly running out in onshore North America, heavy oil is poised to play a more important role and CNQ is dominant in that asset-plus 50% of its production is now gas." Canadian 88, Progress Energy and Cequel Energy, he says, are all prime examples of producers with recycled, proven management teams that have recapitalized these entities and are now growing their undervalued but solid asset bases. Comparing the firm's Canadian and U.S. oil and gas holdings, Huang observes, "The shares of Canadian companies tend to be cheaper, so we're finding more value opportunities up here."