This oil and gas stock is a contrarian buy

Natural gas prices have plunged since last fall. And so have the shares of oil and gas stock Arc Resources, a natural gas producer. In fact, they now trade at a multi-decade low. Is this an opportunity for contrarian investors who can tolerate a high degree of uncertainty?

Lower commodity prices have weighed on the shares of oil and gas stocks over the past 12 months. Stocks heavily weighted to natural gas production have been particularly hard hit, with the price for this commodity down nearly 22 per cent since the beginning of the year.

Oil and gas stock Arc Resources Ltd. is heavily weighted towards natural gas production and its fallen share price reflects this.

Calgary-based Arc Resources Ltd. (TSX—ARX) is one such stock. And it hasn’t helped that the company has responded to lower commodity prices by reducing its planned capital expenditures. On June 20, it announced it will reduce its capital expenditure program for 2019 by 10 per cent to $700 million, and its 2020 program by 22 per cent.

Arc Resources is one of Canada’s largest oil and gas companies. About three-quarters of its production is natural gas. Its operations are focused in the Montney region in Alberta and northeast BC, and the Pembina Cardium region in Alberta. Montney is considered a key growth area with great potential for continued reserve and production additions, while Pembina is one of the largest, most prolific conventional oil fields in Alberta.

Arc explains its spending cuts

Management has described its decision to reduce expenditures as follows: “Arc’s reduced capital investment levels are consistent with our long-held principles of stewarding low debt, sustainable dividends, and investing capital when it is profitable to do so.”

Given these considerations, we view Arc’s decision as prudent. Its average net-debt-to-cash-flow ratio is forecast to be 1.1 this year. This is well within our comfort zone of no more than 2.0, giving us confidence the company will be able to adequately manage its debt.

As for the monthly dividend, management remains committed to maintaining it at its current $0.05 a share. This amounts to a reasonable 30 per cent of forecasted 2019 cash flow of $2.01 a share. A reduction in capital expenditures will help the company maintain the current dividend. But, though we don’t foresee a dividend cut in the near term, commodity prices are fickle, and a substantial, unexpected decline could alter the situation dramatically.

Arc likes to live within its means

Another thing Arc wants to do by cutting capital expenditures is to live within its means and invest only when it is profitable to do so. By reducing capital expenditures, the company increases the chance it will be able to at least nearly fund its spending and dividend payments out of its own cash flows this year.

So while the reduced spending plan is a disappointment in that it will delay Arc’s Attachie West Phase 1 project in the Montney region—a project that is regarded to have great potential—it’s a sensible move that shows the company is being responsibly managed. It also reinforces our confidence that management will be able to successfully execute on such projects in the years to come. Yielding 9.4 per cent, Arc is a contrarian buy for strong total return potential if you can tolerate the uncertainty of volatile commodity prices.

Contrarian investing involves some problems

So far this year, the bulls have prevailed in stock markets. Contrarian investors who bet otherwise have suffered accordingly.

That brings to mind some of the problems of contrarian investing. To some investors, contrarian investing means you simply need to figure out what ‘everybody’ else thinks, then do the opposite. This has gut appeal because it sets its practitioners apart from the general run of folks. Another advantage is that it relieves you of the need to figure out what’s going on in the market or economy.

Trouble is, the contrary approach can be as pitfall-riddled as any other. What’s more, popular opinion on the market rarely reaches that crescendo of unanimity where it pays to blindly go counter to it.

Contrary opinion is worth keeping in mind. But you also need to note that the majority can be, and indeed often is, right for long periods.

This is an edited version of an article that was originally published for subscribers in the August 9, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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