Inflation Nation and Prices at the Pumps with Eric Nuttall

Gasoline prices are 48% higher than they were a year ago and talk of a recession is hitting a fevered pitch. What does this mean for oil sector investors? Ninepoint’s
Eric Nuttall tells Michael Hainsworth this time isn’t like the 2009 recession and there are ways to protect against the pinch at the pumps.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

Michael Hainsworth:
Ah, the summer driving season is here. We are paying almost 50% more for gas today than we did a year ago. Politicians in the UK are clawing back energy industry profits. The US is talking about a gasoline tax holiday. For the world's top energy investment manager, his hedge against the pump price pinch is in the investments he's made in the sector. The Ninepoint Energy Fund is outperforming the market with a 130% annualized return, but there are calls for a recession and these types of conversations tend to create self-fulfilling prophecies. The more we talk about one, the more the public pulls back spending with the private sector following suit. I began my conversation with Eric Nuttall with this. What's the historical oil demand response during a recession? And what does it mean for investors?

Eric Nuttall:
It's a very good question to ask and a good topic to start off with because it's very, very clear that this is dominating markets concerns about demand destruction, the implication for the oil price, et cetera. And what confuses me is that this is something that not only have we been writing about, but we've been forecasting for well over a year. And in fact, it's something that the market needs. The energy market, the oil market is so chronically undersupplied, especially given these structural challenges to supply growth going forward that the only way to balance the market is through demand destruction. We had dinner with the Secretary General of OPEC two weeks ago. Earlier that day, he had noted at a conference that OPEC is very clearly running out of spare capacity at a time when US shale growth is capped, at a time when the global super majors had the inability to grow as they haven't been investing for the past seven, eight years in sufficient projects.

And so we've already had this mismatch between supply and demand, inventories have been collapsing by the fastest pace in history. This is while China is just now slowly merging out of COVID lockdowns from their zero COVID case policy. And so we cannot have inventories fall much further. And so we've been calling for the necessity for demand destruction. And yet this is what is causing a panic, not just in the oil price, but in energy stocks, as people are concerned about, well, geez, we go into recession, demand falls. I would note that it is extremely rare in history to have periods of demand falling. We have recency bias from COVID in 2020 when the world literally shut down and oil demand fell by as much as 30 million barrels per day. But usually in a recession, we're not talking about negative demand growth. We're talking about a moderation in the rate of growth. I.E, there is still a necessity for supply growth, and that's where we see the challenges.

We're coming up short in terms of beyond US shale with the imminent exhaustion of OPEC spare capacity, where exactly are the barrels going to come from? And so with that context, we look at energy stocks today discounting we think $55 or lower. And yet, today, for example, we have stocks falling 8% because oil's falling from 110 to 102, but they're discounting 55. And they're trading, a current oil price, they're trading at 35% free cash flow yields and they've pledged to give it all back to us in the next six to nine months. And so there's this disconnect. It's very, very clear that the market is being driven by fear. Fear can stand for false evidence that appears real. We track inventories in real time. We get the best data we can possibly get our hands on and we are seeing nothing to suggest that there's a strong, any frankly, deterioration in our macro call.

Michael Hainsworth:
I'm glad you explained what that acronym of fear means because I've been seeing you tweet nothing but F.E.A.R over the past little while. Tell me about though OPEC scaling back production to keep prices up. Is that a likelihood as we see not demand destruction because of the potential or the likelihood or the actuality of a recession, but the slowing of demand growth?

Eric Nuttall:
Yeah, so we know that OPEC has a playbook that works. It's a playbook that is allowed during a time of historic demand destruction to balance the market, to get an oil price closer to what they require to be going concerns literally as nations. And so they will have brought on officially, all of the curtailed volumes in the next two months. And so we look to September, we think OPEC is generally out of real spare capacity. You have surge, you can pull on your wells harder for a short period of time, but what we are defined as actual true sustainable capacity, they're out.

And so, yeah, we don't want to have to rely on it, but the insurance policy is, we have a shock, but my God, history is on our side in terms of, there's very, very, very rare to have periods of negative demand growth. You've got to go back to the financial crisis of 2009 or COVID, before that it's extraordinarily rare. What most people don't realize when we're talking about a recession, would the world's thirst for oil still grows, it's just at a moderated pace. But what I'm trying to get across is the market is so undersupplied already that that very fear is exactly what we need to avoid inventories drawing further and propelling oil price meaningfully higher from here.

Michael Hainsworth:
So the solution to high prices is high prices?

Eric Nuttall:
Well, we need demand destruction. Historically, you would've seen a supplier response and we can't get it. Why can't we get it? What we're seeing is the investors, the very owners of the businesses saying we've endured like in my gosh, the past few days or week that we've gone through with energy stocks falling 20, 25%, the worst week for us since March of 2020. And so if anybody thought these guys were going to be going out and blowing their brains out and spending, we clearly do not. We met with a variety of shale companies two weeks ago. What is very, very clear is our call for return of capital is the new religion.

And every company is following it. And the template going forward is 75 to 100% of free cash flow is coming back to investors. And so the cure for high oil prices being high oil priced historically, you would've seen a supply response. We cannot get a supplier response. Now, OPEC's out of capacity, Saudi Aramco are the most technically savvy energy company on this planet is growing their capacity. And they said, "It's going to take us five years to add a million barrels per day of new capacity." And so cycle time matters. Cycle time is the reason why we ran a five to six or longer year blow market for oil.

Michael Hainsworth:
You've been banging the drum on share buybacks for quite some time now, and we're starting to see it. The industry has found religion on this point. When it comes to Canada meeting its climate change goals, while at the same time trying to address the inflationary aspects of energy prices at the pumps. My other relationship with the C.D. Howe Institute has been writing in connection with others, that there's going to be a need for Ottawa to be able to talk to the industry about putting some of that cash into more sustainable practices. Do you see that as something that will come to be?

Eric Nuttall:
Canada is already a leader in ESG in terms of global oil production, any country on this planet, there's not another country that has the environmental standards that we have. Our industry has already pledged to reach net zero by 2050. We have the technology to accomplish that largely through CCUS of carbon capture and storage. We now have a template from the federal government in terms of how much they'll be funding it. And we've got a commitment for industries. So frankly, I don't know what more people can possibly ask. We already produce energy, both natural gas and oil in the cleanest and most ethical and sustainable manner of anywhere in this world. And even beyond that, we've pledged in net zero by 2050.

Michael Hainsworth:
I want to come back to the price that we're looking at right now. From a technical perspective, WTI has broken below the simple moving average about three times this year, hasn't really spent much time below it. What's your expectation for the price through the remainder of the summer driving season, considering what we're talking about here on recession, and the idea that OPEC plus may scale back production to keep prices up. Because at this point it really can't turn the spigots any looser between now and the next five years.

Eric Nuttall:
Let's remember there are two markets for oil. There is the physical market, which is about 100 million barrel per day market. And then there's the financial demand for oil, which is about 30 times bigger than that. And so making any short term calls on oil, we need to realize that things can undershoot and overshoot fundamentals. And so to have oil down today five bucks. On literally, like I woke up, opened up my Bloomberg term and oils down $5. It's like, "Okay, what did I miss?" I check Twitter. I check Bloomberg oil top news, and there's literally nothing. And so the market is being paralyzed by fear, fear of potential demand instruction, which is not showing up in data. And we track it as closely as we possibly can. And so the financial demand for oil can wein even when the physical demand for oil does not.

I think energy investors just have to remember that our biggest challenge now is tune out the noise and focus on what matters and what matters to me is that we're seeing no evidence of demand destruction, yet we need it. We just met with a variety of shale companies. They are not going to be growing meaningfully. We'll never see double digit growth ever again. The head of OPEC told an open room and then later that evening to myself in the plainest words possible that they are running out of spare capacity in the next couple of months and the global super majors, whom we've always relied on to bring on these large, complicated, meaningful projects, haven't been investing for seven years.

To me, that's what matters. And so we're going to get whipped around on the day to day. But when I have my average hold in trading at a 35% free cash flow yield, and they've pledged to give all or most of it back to me imminently. To me, that's really what I want to focus on. It's just this, although the fear again, the acronym false evidence that appears real is poison. It paralyzes and prevents people from making or taking meaningful action.

Michael Hainsworth:
What's the demand curve look like from China following their lockdowns?

Eric Nuttall:
It's, they're slowly emerging. Domestic air travel really plunged, that's slowly improving. International hasn't recouped, but generally speaking, we are seeing a strong rebound, or it's going to be slow and gradual, but a strong enough for a rebound.

Michael Hainsworth:
When you talk about domestic air travel, it makes me think of the article I recently read about the grounding of Russia's fleet and the impact that the Ukraine war, the invasion of Ukraine is having. Tell me about that, is that a blip on your radar, or is that a significant data point?

Eric Nuttall:
The confusion around the impact of what is happening in Ukraine on the energy markets, people are not getting what really matters. And that is, we are going to have the former second large exporter of oil in the world, starved of both capital and technical knowhow. Meaning every major oil company has walked from country taken multi-billion dollar writedowns and they're not going back anytime soon. The largest service companies in the world have pledged no further work. And in fact, some of them were even liquidating their assets. And so when Russia produces the same as Saudi, but they do it from 20 times the amount of wells, wells go down all the time.

And so there's, there's all this necessity for both capital workovers, technical knowhow, polymer floods, et cetera, to maintain production, let alone grow it. And now we see Russia going forward, having the lack of access and ability to do that. And so it's really a medium to long term story. The whole notion about, well, my gosh, peace breaks out, which we all pray for, of course, and sanctions, and what's the impact? And always the risk premium and oil falls, et cetera, that is noise. There has been no physical impact yet on either production or inventories, even though there is an anticipation that Russian oil could, or production could fall by a million, million and half barrels per day in the coming quarter. That is not embedded in our thinking.

Michael Hainsworth:
We learned this week that the annual inflation rate in May rose 7.7% over last year, and the largest increase since January of 1983, gasoline prices are up 48% over last year. Will continued interest rate hikes by the Bank of Canada have any effect on prices at the pumps?

Eric Nuttall:
I don't think so. No. Yeah. We're talking about a mismatch between supply and demand, of course. So we have people emerging from lockdown, wanting to travel. We've got the summer driving season that we're fully into now, but at the same time, we've had about four million barrels per day of global refining capacity removed from the market. These are very cumbersome, expensive operations, and companies simply didn't invest the money because they had politicians telling them that they're going to be decarbonizing and electrifying the fleet. And therefore, why would you spend billions of dollars certainly to bill out new capacity? And so with demand increasing and supply remaining constrained, there shouldn't be a meaningful erosion in gasoline prices unless the oil price falls, which is not our base case expectation.

Michael Hainsworth:
The US president's calling for a gasoline tax holiday, how likely is that? And can you even quantify the impact that the world's biggest economy cutting prices at the pumps would have?

Eric Nuttall:
Yeah. I saw one estimate that it would be really dominous and frankly, it's the opposite of what we should be doing right now. What politicians should be trying to do is encourage supply growth. Even though I think that's hugely challenged because the owners of the businesses don't want it, but they shouldn't be doing something to use demand even further. That's just additive to the problem. So it's like the, what's the dumbest energy policy we've seen? It's the UK coming out with a windfall profit tax. You're stealing money from energy companies while you're trying to get them to invest. So you're crimping supply growth, but then specifically they're using that to rebate energy consumption for the consumers. And so we're allowing an increase in demand while crimping supply growth. It's the opposite of what energy policy makers should be doing.

Michael Hainsworth:
What's the solution? Because even if we manage to get the industry to loosen the spigots by way of doing more exploration, as you point out, even for OPEC, that's a five year tail, that's not a short tail solution.

Eric Nuttall:
There's no easy fix here. What we think is going to happen is oil is going to rally high enough to kill demand growth. And it's got to stay at that level to allow the global super majors to start spending and then to bring on meaningful production ads, to associate demand growth at that time. And so the question is, well, what is that oil price? And how long does it have to stay there for? And so historically that would've been about $180 oil. That's when GDP being spent on oils about six to 7%, that's likely lower now, given the inflation that we're seeing elsewhere, and nobody truly knows. But what I can tell you now is we certainly are not seeing demand destruction. We're seeing complaining. People don't like it, but they're not changing their behavior. We need oil price to go high enough to change behavior.

I'm guessing that's about $150. Now, importantly, how long does it have to stay there to give the global super majors confidence enough to start investing? And when they do, then now we're talking cycle time. The world relied on short cycle US shale for the past eight years. And it would take four to six months to bring on a well. What we're now talking about is long cycle. We're talking four to six years to bring on new production. And so it's the very reason why I say we are in a multi-year, bull market for oil. Why is it multi-year? Why do I save five to six years or longer? Because that's cycle time. That's how long it's going to take the super majors to bring on projects. And they are not in the spending mindset as of today, we need to get them there.

And the only way to do that is for politicians to stop attacking them and allow the oil price to go high enough and stay there long enough to encourage investment decision making and to have investors, to allow them to make that investment rather than doing share buybacks and dividends. And so I look at myself as one example in Canada, what would allow us to say to our holdings, "Okay guys, go out and grow." And what we need is a rerating and share prices to not be able to justify share buybacks. In my mind, that's an oil, that's a energy price, it's rally on average, by about 200% given the bludgeoning we've had.

So stocks have to go up 200% from current levels before I could start to say, "Okay, I don't think buybacks are a good use of your free cash flow at which point, let's just pay me in the form of a variable dividend." And so to answer your question specifically, what is the solution? What is the fix? It's higher oil prices, and it's not just them going high enough, but it's them staying there long enough to both kill discretionary demand growth, and allow sufficient investment. And it's the very reason why I find the sell off in the past week to be so unbelievably frustrating because people are panicking about the very thing that the oil market needs to avoid significant, further draw downs and inventory levels, which will only propel the oil price up higher.

Michael Hainsworth:
Let's go further up the pipeline then. What do margins look like at the refinery level? And how does that compare historically?

Eric Nuttall:
Yeah. Refining margins are obviously extremely robust. Now at the same time, the input costs a lot of the refiners use natural gas. Natural gas prices have risen materially, largely as a result of what's been happening in Russia, Ukraine and the need to diversify cold demand, et cetera, of some warm weather that we're having as well. And so their input costs have gone up as well, but profitability for the refiners is extremely robust now. And we would expect that to continue for the foreseeable variable future.

Michael Hainsworth:
Are these the bad guys in the pump prices we're seeing?

Eric Nuttall:
The bad guys are the politicians. It's the very people throwing stones because the drive for ESG, the drive for decarbonization, the drive for divestments, the calls to throw energy executives in jail for their climate crimes, all of those things, all it did was create an environment of profound, lack of confidence by both the energy companies and energy investors. It led to an implosion in share prices. And now that this industry is experiencing record windfall of profits, we can use that term. Now, the politicians who were responsible for the catastrophe of the past couple years are now saying, "Well, please guys go invest, because we need you to because I've got an election in three months and I'm going to get my behind handed to me if I don't bring down the gasoline price.

And so it's not oil companies who have endured the worst bear market in history, now they're finally just experiencing free cash flow and politicians want to take it away. It's not the refiners having the inability to invest and being told that their services were no longer necessary. Thank you very much, because we're all going to be driving electric cars in the next couple of years. Why bother putting the investment? This is a sunset industry after all, we were told. And so I put most of the blame on the very people that are throwing stones today.

Michael Hainsworth:
You've seen the Ninepoint Energy Fund series, a climate annualized 130%. The series F is up 132%, each beating the benchmark by about 15 percentage points. Are you rebalancing?

Eric Nuttall:
Rebalancing to what?

Michael Hainsworth:
Well, okay.

Eric Nuttall:
What we're doing is topping up positions on names that have sold off by 20, 25% in the past two weeks where we see on average they're trading at 35% free cash flow yields, trading at two times or less their enterprise value to their cash flow. Companies that we estimate are going to be debt free in the next two to three quarters at most, and who have all pledged to us to return 75 to a 100% of their free cashflow back to us in the form of buybacks and dividends.

And so if anybody's not whatever they feel comfortable with, energy is a percentage TSX today sitting at about 20%, whatever people think they want their allocation to be, my own strategy is to use the fear of the day, that false evidence that appears real, that worry that my gosh, we're going to get demand destruction cause we're entering into a recession and such. And people who are fearful of the very thing that not only have we been forecasting and predicting, but the very thing that the oil market needs and you can take advantage of that fear.

It's the same feeling that we had in March, April of 2020, when we were all told this is the new normal, we're all going to be working from home forever. No one's going to be flying ever again. And that fear paralyzed many people from taking advantage of what was then a generational opportunity. I feel today with every fiber in my being that energy stocks represent a tremendous generational opportunity just as they did in March and April of 2020. We project, we think that there's very material upside in energy stocks in what we believe very strongly to be a five to six year or longer multi-year bull market for oil.

Michael Hainsworth:
All right, you ready to take some tweets?

Eric Nuttall:
Let's do it.

Michael Hainsworth:
280 characters or less. We got tweet from Scott asking, despite it making no sense, do you think that the Canadian government will put a windfall tax on oil and gas?

Eric Nuttall:
Yeah. This is a very common question that I get. Let's remember that at the time of the formation of the coalition between the NDP and liberals, the NDB tabled such a thing, the conservatives vote against it. And more importantly, the liberals abstained from voting, I.E they voted against it without voting against it. The era apparent, I would say of our next prime minister under the current government, I think is much more knowledgeable in terms of the role that energy has of our economy.

That we're not like the UK, we're not like US. It's not 5% of our market and less than that of our overall economy. In Canada, the energy sector used to be 15% direct, indirect of our economy. And so as there's a necessity to dig ourselves out of the fiscal hole that we find ourselves in, especially as the housing market is potentially vulnerable to rising interest rates, my understanding is the government is aware of the need not to kill the golden goose. I would never expect them to be the biggest champion of the sector, but I don't think they're going to do anything stupid to it either.

Michael Hainsworth:
Vancity Manny is asking for your thoughts on Vermilion resources and ARC resources in this quote, terrible macro sentiment.

Eric Nuttall:
Yeah. I'm going to avoid doing stock specific questions that just gets me into tricky compliance issues. But what I would say is, our focus remains on Canadian oily mid-cap companies that are going to be debt free in the next couple of quarters who are generating record free cash flow and have pledged to return most, if not all of it back to us in the coming months and quarters in the form of buybacks and dividends.

Michael Hainsworth:
All right, here's your cocktail party question from Hugh. He asks you, are oil and gas companies making even more record profits during this time where people are struggling to make ends meet?

Eric Nuttall:
Yeah. Clearly the after enduring the worst bear market in history where energy companies were staring into the abyss two years ago, where energy stock prices fell by 80, 90% in many cases, as a result of the vilification and demonization of this sector, given the introduced lack of certainty in spending and such and now the mismatch between supply and demand and record low inventories, oil companies are obviously benefiting from that. And will, I think continue to benefit from it, generating record free cash flow. It's up to the individual to decide whether they want to participate in that free cash flow windfall by becoming an owner and potentially hedging yourself against many of the inflationary pressures that you're facing at either the gas pump or at the grocery store.

Michael Hainsworth:
We've talked about this before, when you fill up at the pump and you see the price on the machine, you're thinking I'm hedging that by being an investor in the companies that are putting this oil in my tank.

Eric Nuttall:
I want everybody to feel the same level of joy that I feel every single time I fill up my car because whatever I'm paying additionally to do so, I'm making many times over by the rising share prices of the oil companies that are producing that product. Owning energy stocks is the easiest hedge that I can think of to protect yourself from the inflation that everybody is suffering from right now.

Michael Hainsworth:
Eric, enjoy the summer driving season.

Eric Nuttall:
Thanks so much.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.