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Natural gas fuels energy funds' performance

High gas and crude oil prices helped deliver healthy returns over the past year

Special to The Globe and Mail

Buoyed by high crude oil and natural gas prices, energy funds have chalked up some healthy returns this year.

In fact, during the recent bear market, investors in the category fared better than most owners of Canadian equity funds, gaining an average annual 10.6 per cent in the three years ended June 30 against an average annual compound loss of 4.8 per cent.

Normand Lamarche, lead manager for the past two years of the $48.5-million CIBC Energy Fund, which rose 24 per cent in the year ended June 30 and has a three-year average annual compound gain of 9.7 per cent, credits his success to an emphasis on natural gas.

"We have moved into natural gas in the last couple of years, which has contributed to our performance and we'll retain a good weighting there," he says.

And he has been venturing further afield.

"Now we are rotating into power utilities, drillers and service companies," he adds. "We like power utilities that can generate low-cost electricity because they'll benefit from the higher electricity prices in the next cycle, and we also like drilling services, because they'll benefit from a secular [long-term] uptrend in spending, a double whammy from both rising sales and margins."

Currently about 55 per cent of his fund is invested in oil and gas producers that are largely weighted to gas and about 35 per cent is in drilling services and power utilities.

Mr. Lamarche says he has been lightening up on oil-weighted producers, adding that there is a growing reliance on crude from unstable parts of the world.

"North America is still the world's third-largest oil producer but it has been in a 30-year consecutive decline and the same is true of Europe."

Increasingly, oil production is coming from areas with a history of political unrest, such as Latin America, the Middle East, West Africa and the former Soviet Union, says Mr. Lamarche, a managing partner of Toronto-based Front Street Capital Inc.

"Recently we've seen disruptions in Ecuador, Nigeria and Iraq and a national strike in Venezuela last winter that paralyzed the whole country and shut down the energy industry for three months."

Iraq is, of course, the most highly publicized wild card in the oil patch, says Ari Levy, an energy analyst with TD Asset Management for the past two years.

He is also the recently appointed co-manager of the $98.9-million TD Energy Fund, which gained 5.3 per cent in the past year and an average annual 10.8 per cent over three years.

"Iraq will need at least six months to a year to produce two million barrels a day, the level it was at before the war, which is longer than we originally expected. People are blaming it on looting and destruction of the infrastructure and on pipeline explosions," he says.

Glenn MacNeill, manager of the $10.1-million Sentry Select Canadian Energy Growth Fund, is also largely focused on natural gas. His fund, which posted a 12.8-per-cent gain in the last year and has an average annual gain of 16.9 per cent over three years, is almost 45-per-cent weighted in companies that have a large exposure to natural gas.

"We favour gas because it is less vulnerable than oil. It's a North American market that is driven by supply and demand while, with crude, there are so many unpredictable variables," he says.

Unlike oil, which is shipped worldwide in tankers, the natural gas market is a continental one, because gas must be transported overland through pipelines, with the exception of liquid natural gas, or LNG, which currently accounts for a scant 3 per cent of North American supply.

But the near-term demand for natural gas is being choked off by a sharp runup in its price this year, says Robert Lyon, a portfolio manager with CI Mutual Funds Inc., and manager of the $42.4-million CI Global Energy Sector Fund.

In the last 12 months, the price of natural gas has jumped to about $5.50 (U.S.) per million BTUs (British Thermal Units) from $3.

Many industries can switch quickly between oil and natural gas and, with higher gas prices, some are switching -- temporarily at least -- back to oil, Mr. Lyon says.

"In late May and early June, gas injections into storage rose at a faster rate than they ever have before, so we should see some softening of natural gas prices this summer," he says.

Most industry watchers expect to see an oil price of between $25 and $26 in the coming year and for natural gas, a price of between $4 and $5.

"I think we could see natural gas at the $5 to $6 level in the next year, but all these companies can make money at $4 for natural gas and they can do well with oil at $25 a barrel or even in the low $20s," Mr. MacNeill says.

"We think oil will stay in the mid-$20s or higher," says Mr. Lamarche.

"We continue to be surprised by the demand picture after two years of sluggish world economic growth and there's not a lot of capacity to raise production -- Saudi Arabia is the only swing producer that could do it," Mr. Lamarche adds.

"Two-dollar natural gas has gone for good and we will remain exposed to the North American gas story," adds Mr. Levy, "but we are also finding good fundamentals in the integrated oil companies."

About 30 per cent of his fund is invested in companies that produce, refine and market oil to consumers.

That includes major positions in Shell Canada Ltd., Suncor Energy Inc. and Petro-Canada.

All of these companies have seen large-scale production increases in the last couple of years, which will continue, he says.

Another 60 per cent of his fund is invested in oil and gas producers, including a large stake in the oil-leveraged Talisman Energy Inc., which trades at only 3.7 times its cash flow.

The fund also holds natural-gas-weighted junior producers such as Progress Energy Ltd. and Cequel Energy Inc., both Calgary-based, which have experienced and widely respected management teams.

Among the power utilities favoured by Mr. Lamarche, a recent acquisition is TransAlta Corp. "It has been under a lot of price pressure in the past year, as have all North American utilities but it has a good balance sheet and access to low-cost manufacture of electricity. It will benefit from an uptrend in power prices in the capital-intensive-spending part of the cycle that we are moving into, with huge projects like the pipelines to Alaska and the Northwest Territories just ahead," he says.

Among producers, he holds larger-cap players such as EnCana Corp., the largest independent natural gas producer in Canada. Like Mr. Levy, he also owns Progress Energy and Cequel Energy.

Mr. MacNeill is almost 40-per-cent invested in larger-cap producers that are weighted to natural gas, including a large stake in EnCana, amounting to almost 10 per cent of the total portfolio.

About 25 per cent is in junior producers, with holdings in Peyto Exploration & Development Corp. and Tempest Energy Corp., both Calgary-based. More than 15 per cent is in integrated oil, with the largest position in Shell Canada.

With a loss of 6.5 per cent over the past year -- but an average annual gain of 5 per cent over the last three -- Mr. Lyon's fund has lagged behind its peers in the short term.

"This is a global fund, with a mandate to hold more international names," he notes.

"The main reason we have not kept pace this year is that we have had less exposure to the junior Canadian oil and gas producers, which did so well," Mr. Lyon adds.

He has recently raised exposure to the integrated oils, because they are less vulnerable to commodity prices and has major positions in U.S.-based Exxon Mobil Corp. and BP PLC.

© 2007 The Globe and Mail. All rights reserved.

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