Bottom Fishing

The MoneyLetter, MPL Communications Inc.133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

With financial markets focused on recent events in Washington - specifically the federal government slowdown and looming debt ceiling - investors have once again been left feeling paralyzed.

But beyond those choppy waters, things are decidedly more positive, which is a good news story on both sides of the border.

True, the decent-but-not-spectacular jobs picture in the U.S. is resulting in an income and spending lift that isn't up to snuff for much of this recovery.

Not only are more jobs required, but the quality of the jobs has to improve. But there appears to be mounting evidence that those higher-quality jobs are on the horizon - a potential catalyst for the U.S. economy.

The housing recovery is well under way in the U.S., although new home starts (a key economic barometer) has hit a plateau in recent months.

But the news is not altogether bad. 2014 is shaping up to be a decent year for the housing sector, with both apartment and single family construction set for a higher peg next year.

Mind you, our forecast for solid mid-three per cent U.S. growth in 2014 would have been severely challenged if the law-makers had failed to find some common ground. To ensure decent growth this year, Washington needs to spread the pain of deficit restraint out over the coming decade, rather than applying the brakes too sharply now.

OIL & GAS

One area of real strength for the U.S. economy has been the explosion of shale gas production along with modest increases in other non-conventional gas sources, such as coal-bed methane.

The strong surge in U.S. production has dented Canada's oil and gas sector in recent years.

Canadian natural gas output plummeted 25 per cent in the last five years as lower-cost production stateside has made inroads into traditional markets for Canadian gas in both the U.S. and in Eastern Canada.

Compounding the misery for Canadian natural gas producers is the persistently large discount between their reference price (AECO) and Henry Hub, the reference price for U.S. producers. The discount has in recent years reached as much as $2 per thousand cubic feet, a massive discount when you consider that Henry Hub, or NYMEX, gas is currently trading at $3.84 per thousand cubic feet.

A glut of Canadian natural gas coupled with higher pipeline tolls for producers (given the longer distance to market) have contributed to this massive price differential.

The consequence of this discount has been the significant under-performance of Canadian natural gas producers versus oil-levered ones on the TSX over the last few years.

Thankfully, there are signs that the period of exceptionally low prices for natural gas is coming to an end. That's good news for Canadian producers.

Granted, we may not be heading back to the days of the past decade where natural gas prices traded in the double digits. But a new norm of North American prices hovering in the $4 to $5 per thousand cubic feet range for the foreseeable future is likely.

Low prices in North America have caused exploration and production (E&P) companies to cut back on activity. Since late 2011, the active gas rig count in the U.S. has fallen by around 60 per cent, the lowest level in nearly 20 years.

As well, natural gas storage levels coming into the all-important winter heating season are about eight per cent below the level recorded three years ago.

In short, less production and inventory have set the stage for a rebound in natural gas prices next year.

Longer term, natural gas prices are likely to be driven by the breakeven, full-cycle cost of producing natural gas from shale.

U.S. shale gas accounts for one third of overall gas production today versus next to nothing a decade ago, but is expected to represent virtually all of the incremental supply growth in the next 10 to 20 years.

Compared to traditional oil and gas development, shale gas is quite labor intensive, in part because of the rapid decline rates experienced in new wells. This rapid decline rate means that new wells must be constantly developed - a contrast to the general perception that natural gas is cheap and abundant.

Proximity to pipelines, gas plants and key infrastructure, coupled with the individual geologies of the ten to twelve major shale plays across the U.S., helps determine the full-cycle cost of each play. (Recent studies have pegged the full-cycle costs of producing natural gas in the lower 48 states at between $4.00 to $4.70 per thousand cubic feet.)

CANADIAN SHALE

While Canadian producers have been taking it on the chin lately, the tide may be finally turning for Canadian E&P stocks. American and European investors riding the shale gas boom in the U.S. are increasingly looking to switch horses as the share prices of many U.S. producers are looking toppy.

Canada's own shale reserves are world class, with over 90 per cent of our shale resources lying in the Montney and Horn River basins in BC and Alberta.

Significant gas volumes are also thought to exist in Quebec's Lower St. Lawrence basin and in New Brunswick and Nova Scotia.

Recent estimates by the U.S. Department of Energy estimate Canada's shale resources at 573 trillion cubic feet, the fifth largest in the world and just 14 per cent less than America's shale reserves. At current rates of production that's equivalent to two centuries of domestic consumption.

The opportunity for a massive boom in Canadian shale gas production is enormous; however, we will need to move quickly on pipeline and other critical infrastructure issues before formidable competition from American and Australian competitors slams shut the window of opportunity for Canadian gas producers.

WHAT TO DO

With the Canadian oil & gas sector badly lagging their peers south of border, and with international investors on the hunt for stocks that have yet to move, it seems like a good time to be buying the Canadian energy names.

Valuations remain attractive, the sector is poised for some considerable growth and there exists the very real potential of a tailwind from strong international buying for the foreseeable future.

One name we really like is Crescent Point Energy (TSX-CPG, $40.17), a predominantly light oil producer whose production has surged to more than 114,000 barrels of oil equivalent per day from about 1,000 in 2003. But this growth has come at a price.

The stock's been in the penalty box because investors have been concerned about dilution from multiple equity issues. Management has responded to these concerns, however, by slowing the pace of acquisitions to concentrate on harvesting its existing assets. The company boasts a yield of 7.12 per cent.

?~> Our Advice: A buy rating and a 12-month target price of $47.50 per share.

EnCana Corp. (TSX-ECA, $18.42) is Canada's benchmark natural gas producer and a company that we also like. It holds large land positions on the Cutbank Ridge, Greater Sierra, Duvernay, Peace River Arch and Bighorn shale gas plays in B.C. and Alberta, and the Jonah, Piceance, Haynesville and Tuscaloosa Marine Shale resource plays in the United States.

EnCana is also building a growing inventory of liquids-rich opportunities in Canada and the United States. The company's shares have lagged natural gas prices this year (as well as the performance of their peers) as the market waited for a new CEO and clarification of the company's strategy.

The new CEO is now in place, and we believe the company is focused on growing shareholder value rather than production and achieving a more sustainable balance between cash flow and capital spending.

?~> Our Advice: A buy rating on this stock and a 12-month price target of $26 per share.

A company that is nicely balanced between oil and natural gas production is ARC Resources Ltd. (TSX-ARX, $27.34). Appropriate for conservative investors, ARC has over 50 trillion cubic feet of natural gas and around 1.5 billion barrels of oil in place.

The company controls approximately 800 net sections of land in the Montney, and is the third largest producer in that play. ARC has a dividend yield of 4.48 per cent and is very conservatively managed.

?~> Our Advice: A buy recommendation on the stock and a 12-month price target of $32 per share.

THE BOTTOM LINE

The market has been obsessed with the shenanigans in Washington of late, and this short-term blip represents an ideal opportunity for savvy investors to go on some bottom-fishing trips.

As we've been highlighting for months, the back-up in yields has signaled the end of the defensive trade and the beginning of a move to early and mid-stage cyclicals (e.g., energy stocks).

Despite having some of the best oil and gas reserves in the world, Canadian energy stocks have badly lagged their U.S. peers.

Large potential returns and attractive valuations position Canadian energy names for substantial out-performance in the months ahead.