/Battered oil and gas companies brace for another setback — exclusion from Canada’s main stock index

Battered oil and gas companies brace for another setback — exclusion from Canada’s main stock index

CALGARY — Some of the country’s largest natural gas producers and drilling companies could soon be booted out of the main Toronto Stock Exchange index amid a share price rout, according to analysts.

After a bruising summer in which their stock prices have fallen to historic lows, as many as seven oil and gas companies are in danger of being removed from the S&P/TSX Composite Index.

AltaCorp Capital published a list of potential deletions from the composite index that includes Kelt Exploration Ltd., Peyto Exploration and Development  Corp., NuVista Energy Ltd., Torc Oil and Gas Ltd., Birchcliff Energy Ltd. and drilling companies Precision Drilling Corp. and Ensign Energy Services Inc., as their depressed market capitalizations have fallen to the point where they no longer meet the threshold required for the 239-member composite index managed by index provider S&P Global Inc.

The problem is the market has just been so beat up through the summer that there just isn’t anybody listening right now to the oil and gas story

Kelt CEO David Wilson

Their deletion would exacerbate the damage already inflicted on the sector because it would preclude major passive funds, that track major indices, from buying the stocks.

“All you can really do is get out in front of the investors and tell your story,” said Kelt president and CEO David Wilson last week. “The problem is the market has just been so beat up through the summer that there just isn’t anybody listening right now to the oil and gas story.”

Wilson said neither S&P Global or TMX Group Ltd., which runs the exchange, have contacted him about a potential removal from the composite index, though he’s aware that Kelt is among the names analysts expect will be removed.

“The fact is, right now, there’s such a lack of investor interest in Canadian energy equities that the stock valuations have gone soft and we’re going to fall off the index. I mean, it’s inevitable based on the numbers,” Precision Drilling president and CEO Kevin Neveu said, adding that being included in the index helps reduce the company’s cost of capital and expands its pool of potential investors.

Given the challenges facing the sector such as the lack of new pipelines, he said the outcome is not surprising.

“When investors can’t see any potential for production growth or enterprise growth, they’ll look for other sectors,” Neveu said, adding that Precision has been trying to demonstrate the value in its shares by buying back stock. Neveu said he’s been buying shares, too.

CIBC World Markets analysts wrote in a note published at the end of August that attributed the decline in Precision Drilling’s share price to “pre-emptive selling in asset managers that can’t own stocks out of the index as well as the traditional shorting that accompanies such index events.”

A survey of index analysts compiled by Bloomberg also flagged Peyto, NuVista, Torc, Birchcliff, Precision and Ensign as highly likely to be deleted from the index. An announcement is expected within the next few days with deletions occurring on Sept. 20.

Bob Geddes, president of Ensign, said he’s been meeting with new investors every day for the last month who “smell a bottom” and believes sentiment toward the sector is shifting. He said there’s been “blood in the streets” the last few years in the oilfield services sector but “a lot of bottom-up buyers are back in the market.”

“I’m never worried about the index,” Geddes said, adding that he’s focused solely on running the company, not worrying about factors he can’t control.

Energy stocks make up 19 of the 50 most shorted stocks on the Toronto Stock Exchange, making it the most shorted sector on the exchange

Peyto, NuVista, Torc and Birchcliff did not respond to multiple requests for comment. All the companies will continue to trade on the Toronto Stock Exchange, but will not be eligible to be re-added to the composite index for a year, if removed.

S&P Dow Jones Indices spokesperson Ray McConville declined to comment on whether a number of oil and gas companies were poised for deletion from the index this month.

S&P did provide a list of criteria for inclusion (and removal) from the composite index that shows any company’s whose value falls below 0.025 per cent of the overall index will be removed and will not be eligible to included in the list for 12 months.

Each of the companies mentioned above had fallen below the index’s threshold at the end of August and could technically drop off the list, which would continue a long-term decline in the number of energy companies comprising the composite index, although S&P could grant exemptions.

The composite index comprised 34 per cent oil and gas stocks in terms of value in 2008, but the weighting has since fallen to 16 per cent.

“It does have a profound impact on the interest level in names,” NinePoint Partners senior portfolio manager Eric Nuttall said, noting there are now substantially more passive investing funds that follow indices than active managers who are trying to beat the market.

“As liquidity in the market has really dried up and there’s been a buyers’ strike, I know that some hedge funds have been shorting these names, knowing that there are no buyers on the other side,” Nuttall said.

A short interest list gleaned from Bloomberg data shows that energy stocks make up 19 of the 50 most shorted stocks on the Toronto Stock Exchange, making it the most shorted sector on the exchange. Stocks with a sizeable short interest include Kelt, Peyto and Birchcliff.

Removal from the index would also mark a victory for some short sellers, who have aggressively bet against the names in advance of the quarterly index rebalancing. Some investors say it could also set off a “fire sale” for active fund managers to buy.

Canoe Financial senior portfolio manager Rafi Tahmazian warned that “your average Joe should not try to get in the middle of this because the powers that be – the big funds that trade the index – are building structures and preparing for potential movements ahead of time.”

However, he sees an opportunity as generalist fund managers are treating oil stocks like tobacco stocks and staying away. The difference is oil and gas are necessity goods and the situation is a “fire sale,” given that oil and gas companies are currently “making gobs of money,” Tahmazian said.

Nuttall said he’s buying stocks below their liquidation value and has recently built positions in Kelt, NuVista and Torc. “The expectation is the names being deleted are actually going to outperform after the event,” he said.

The absence of these companies from the main benchmark could take a toll on Canadian energy investors and executives.

“I think it gets to a point where capitulation sets in. Everybody says, ‘why invest in oil and gas?’ then all of a sudden these companies are trading at such low multiples that it becomes a great investing opportunity and guys jumps back in,” Kelt’s Wilson said, adding that he has also been buying the company’s shares.

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