To call the Canadian energy sector challenged would be quite the understatement: Many companies have sold off to 2009 recessionary levels even though crude oil prices are setting new 52-week highs.
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That said, we’ve identified some bright spots during our regular quarterly due diligence that could represent opportunities for investors.
Investors paying for income
Investor demand for income has shifted available capital toward those companies that pay a healthy dividend. The same applies to the Canadian energy sector, which has spawned a number of higher-yielding companies in order to tap into this capital base.
There is also a cost-of-capital advantage as many of the dividend-paying energy companies have outperformed those focused solely on delivering growth. For example, the Canadian High Yield Energy Index is up approximately 7.5% this year compared to 3.5% by the S&P/TSX Capped Energy Index.
In addition, dividend-paying companies that have stronger balance sheets and lower payout ratios currently trade at a premium to those with high debt levels.
Finally, TD Securities recently put out an interesting piece noting the valuation gap between junior producers and the intermediate-sized yield producers has widened to record levels as the intermediates are trading three multiples higher on 2013 expected cash flow (8x versus 5x). This leaves a lot of room from an M&A perspective for juniors to sell at reasonable premiums to current levels, therefore once again becoming feedstock for income-paying intermediates.
Improving cost structures
We’ve come across a number of comments by senior management about the noticeable improvements in drilling, completion and overall operating costs enabling stronger profitability. Some companies also stated they now have much better access to 24-hour drilling crews, allowing quicker development turnaround times. This corresponds somewhat with research that shows an 11% expected yearly improvement in operating costs.
Some of the smaller oil sands companies are also really struggling to find capital to fund their projects. However, we view this as a positive for the larger senior oil sands players that are developing expansions on their existing projects. This is because the delay in new projects should help alleviate some of the cost pressures and improve the economics of these expansions.
Many of the oil producers have also stated they plan to take advantage of the current oil price environment by increasing their hedging program. This isn’t surprising given that Western Canada Select heavy blend crude is trading at only a $15-a-barrel discount to West Texas Intermediate, compared with a $40 discount back at the beginning of the year. Hedging programs have already risen to 35% to 40% of 2013 expected volumes from 20% to 25% in January.
Strong upcoming quarter predicted for oil producers
Given the rebound in pricing, we’ve heard there are going to be some very strong second quarters by some of the oil producers, which could result in some upside when they report in the coming weeks.
The only risk is that it has been a somewhat wet quarter and that has impacted some drilling programs and production targets. However, Alberta Environment data shows most of the above-normal precipitation has been along the Alberta foothills region, although June on the whole was a very wet month across the province.
Very attractive valuations
There is tremendous value in the Canadian energy sector, especially among oil-focused producers. For example, WTI oil prices are up approximately 17% this year compared to a 3.5% rise by S&P/TSX Capped Energy Index.
National Bank Financial research, as at July 4, 2013, shows the senior oil producers are reflecting a 30% discount to current oil prices, while the intermediates carry a 20% discount. We believe this disconnect cannot continue and will eventually mean revert, just like what happened between the Brent and WTI spread.
Martin Pelletier, CFA, is a portfolio manager at Calgary-based TriVest Wealth Counsel Ltd. Note: The Canadian High Yield Energy Index was created by Trivest.