Quarterly Investment Guide

Buffett’s value bet on Canadian energy stocks

Last June, Warren Buffett's Berkshire Hathaway surprised a number of investors by sinking more than $500 million into Suncor Energy (NYSE: SU), one of Canada's largest oil-and-gas companies.

To Americans, it may have seemed like just another one of the Oracle's undervalued plays, but it got a lot of long-suffering Canadian energy fund managers excited. This once booming sector has been underperforming over the last few years, and Berkshire Hathaway's bet could be a signal that it's finally coming back to life.

A sign directing traffic to the Suncor Oil Sands, north of Fort McMurray, Alberta, Canada.
Brett Gundlock | Bloomberg | Getty Images

Since 2009, U.S. oil-and-gas producers have dramatically S&P Oil & Gas Exploration and Production Select Index outperformed Canadian ones. The index is up about 150 percent over the last five years versus 30 percent for Canada's S&P Capped Energy Index.

While Buffett hasn't said explicitly why his company bought nearly 18 million shares of Suncor, it's likely this underperformance played a part in his buying decision. The shares are up 17 percent since June 30, and while he sold 5 million shares in December — for a gain of about 20 percent — he still owns nearly 1 percent of the company.

"He's a deep-value guy and likes to buy businesses that are undervalued over the long term," said Martin Pelletier, a fund manager with Calgary-based investment firm TriVest Wealth Counsel. "And Canadian energy has been in a sideways market."

If you want to be like Buffett and his lieutenants then consider the Canadian energy space. This multibillion-dollar industry accounts for 6.8 percent of the country's gross domestic product and employs more than 280,000 Canadians. It's also a net exporter of oil and gas, with about 90 percent of its energy exports heading to the U.S.

With global demand for oil and gas only rising — the U.S. Energy Information Administration predicts energy consumption will jump by 56 percent between now and 2040 — the need for Canadian energy is going to continue to increase.

Today, Canadian oil-and-gas producers are less expensive than their U.S. counterparts, but the sector should offer plenty of upside to patient investors.

Boom on bust

It wasn't long ago that the Canadian energy space was one of the most promising markets for investors. Between November 2000 and June 2008, the S&P/TSX Capped Energy Index climbed by 387 percent.

Things started changing when the U.S. struck black gold in North Dakota in 2008 and began producing more of its own oil. Investors — even Canadian ones — began looking for fast-growing buys south of the 49th parallel.

There are other reasons for Canada's sluggish growth, including a large price differential between Western Canadian oil and West Texas Intermediate crude (WTI). While there's always a bit of a gap between the two prices, in the fall of 2012, Canadian oil was $40 cheaper than WTI. That was unusually wide, said Pelletier, and it hurt a number of companies.

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Most experts blame the gap on poor energy infrastructure — it's becoming increasingly more difficult to ship oil from Canada to the U.S. Gulf Coast, and that's causing a backup in supply. While some companies are now shipping oil by rail, many people think that if Keystone XL can get approved, the supply problem will be resolved.

"[The lack of infrastructure] has been a big factor, and it may be again," said Les Stelmach, a fund manager with Franklin Templeton Investments, a global investment firm. "It's impacted the ability of Canadian oil-and-gas producers to get oil to market, and that adds to the uncertainty."

Investors have also been dismayed by the Canadian government's hesitations around oil-patch buyouts. In July 2012, China's CNOOC (NYSE: CEO) made a bid to buy Calgary's Nexen for $15 billion, but no one was sure if the federal government would approve the purchase. It did, but Prime Minister Stephen Harper made it clear that the country's biggest energy players, which control much of the country's natural resources, weren't for sale.

"That's one of the reasons why Canadian energy valuations got eroded by a [couple of] multiple points," said Craig Basinger, chief investment officer at Richardson GMP, a Toronto-based investment firm. "All of a sudden, a potential buyer is allowed to do a joint venture and that's it."

Long-term opportunity

Over the next two or three years, the U.S. shale oil play will continue to look attractive — especially for growth investors — but America's boom times will come to an end by 2019, said Amir Arif, a Washington D.C.-based analyst with investment banking firm Stifel, Nicolaus & Co.

There are already signs that the U.S. light-oil market is becoming oversaturated, said Arif. Historically, Louisiana Light Sweet Crude has traded at a $1 or $2 premium to Brent Crude, but American crude is now $10 cheaper than European oil. That's partly due to an increasing amount of supply, he said.

He also pointed out that the decline in U.S. oil production is becoming steeper every year. Many of the wells that have contributed to the American energy boom produce the most oil in their first year of production, he said, and then drop from there.

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It's been reported that some wells in North Dakota's Bakken region saw production decline by about 70 percent 12 months after drilling began. Arif believes that total oil production will decline by 80 percent within five years.

"That's the scary part of shale," he said. "Once you start running out of quality inventory, then the ability to maintain the growth will become a tricky issue."

The Canadian market is different in that many of the mines run by major players, like Suncor and Canadian Natural Resources (NYSE: CNQ), have reserve of 40-plus years, said Arif.

There's also a lot of heavy oil coming out of Canada, which has better long-term supply and demand fundamentals than light oil, which is mainly what's coming out of the U.S.

All of this adds up to a good opportunity for long-term-value investors.

"This is an attractive space for people who want exposure five or 10 years out," he said.

While investors may have to be patient for big returns, Canadian valuations may be attractive enough for some to buy in today and then hang on. If you look at the sector on a debt-to-cash-flow multiple, Canadian energy and petroleum companies are trading at 1.5 times, while the U.S. sector is trading at 2.5 times, said Pelletier.

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On an enterprise value-to-EBITDA basis, which is how Arif looks at energy companies, the largest Canadian operations are trading at about 5.5 times, while the U.S. companies are closer to 6.5 times.

What to look for

Canada's energy dilemma
Canada's energy dilemma

There's a good reason why Buffett bought Suncor and not one of the many other Canadian energy companies out there, said Arif, who covers the stock. It lines up with all of the things an investor would want in a long-term Canadian energy play.

Investors should look for a company that has more existing production than new production, such as Suncor, as cost overruns are often a problem when looking for fresh supply.

You also want companies that produce and refine their own oil, such as Canadian Natural Resources, Suncor and Imperial Oil (NYSE: IMO). Operations that have a hand in the entire process and can sell the finished product themselves — often at WTI prices — are less susceptible to the oil price differential problem.

Also look for companies that have slow decline rates and long-life assets.

The best returns are in heavy oil producers in Grand Prairie, Alberta, said Stelmach. Businesses such as Baytex Energy (NYSE: BTE), or larger companies, such as Suncor, which have the money to spend developing the region—are attractive, he said.

It comes down to patience, said Franklin Templeton's Stelmach, but if you can wait it out, then the returns will come.

"Everyone likes to read Warren Buffett's mind, but I think he's seeing long-life oil reserves from a friendly country that's neighbors with the biggest consumers in the Western Hemisphere," Stelmach said. "He plays the long game and sees the value from that."