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Outlook for Oil & Gas Canadian E&P Industry Remains Favorable

Nilanjan Choudhury

The Zacks Oil and Gas - Canadian E&P industry consists of Canada-based companies focused on exploration and production (E&P) of oil and natural gas. These firms are engaged in finding hydrocarbon reservoirs, drilling oil and gas wells, and producing and selling these materials to be refined later into products such as gasoline.

Let’s take a look at the industry’s three major themes:

 

  • While oil production is surging in Canada, the country's exploration and production sector has remained out of favor, primarily due to the scarcity of pipelines. In short, pipeline construction in Canada has failed to keep pace with rising domestic crude volumes – the heavier sour variety churned out of the oil sands – resulting in infrastructural bottleneck. This has forced producers to give away their products in the United States – Canada’s major market – at a discounted rate. As it is, Canadian heavy crude is inferior to the higher-quality oil extracted from shale formations in the United States and is also more expensive to transport and refine.

 

  • The deep discounts, which expanded to a staggering $50 per barrel late last year, led the former Alberta government (of Premier Rachel Notley) to issue a mandate on Dec 2, 2018 to remove 325,000 barrels of oil production per day from the market beginning in 2019. While the unprecedented output cuts – relaxed in subsequent months – have brought down the price gap to a large extent (less than $15 now), the production curtailment has forced a number of Canadian energy producers to trim their capital expenditure budgets for 2019 as they can’t boost output growth. Meanwhile, the government intervention, which will run through year-end 2020, and lack of spending opportunities have left the large Canadian energy companies flush with funds that they intend to utilize for dividend hikes, share buybacks and debt reduction.  

 

  • The positive final investment decision for Royal Dutch Shell’s (RDS.A) LNG Canada project is seen as a significant turning point for the country’s energy industry. The initiative, located in Kitimat, British Columbia, is estimated to cost C$40 billion and marks the nation’s largest infrastructure project ever. While the production of gas is soaring in Canada, lack of pipeline construction and export facilities are forcing producers to sell their products at a discounted rate (just like oil). The LNG Canada project is expected to start exporting the super-cooled fuel to Asia by 2024 and will likely provide a fresh lease of life to Canada’s gas industry. The additional export facility (with a 40-year license) will certainly help mitigate the oversupplied gas market of Canada, which has debilitated the commodity’s price in the country for the past few years.

 

Zacks Industry Rank Paints a Picture of Improving Outlook

The Zacks Oil and Gas - Canadian E&P is a 9-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #106, which places it in the top 42% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates bullish near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s position in the top 50% of the Zacks-ranked industries is a result of positive earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are gradually gaining confidence in this group’s earnings growth potential. As a proof, the industry’s earnings estimate for 2019 has increased 49% since Feb 28.

Before we present a few stocks that you may want to consider, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Lags Sector & S&P 500

The Zacks Oil and Gas - Canadian E&P has lagged the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.

The industry has declined 39.1% over this period compared to the S&P 500’s gain of 1.4% and broader sector’s decrease of 21.5%.

One-Year Price Performance

 

 

Industry’s Current Valuation 

Since oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of noncash expenses.

On the basis of the trailing 12-month EV/EBITDA ratio, the industry is currently trading at 5.1X, significantly lower than the S&P 500’s 11.22X. It is, however, slightly above the sector’s trailing-12-month EV/EBITDA of 4.75X.

Over the past five years, the industry has traded as high as 20.18X, as low as 3.54X, with a median of 7.75X, as the chart below shows.

Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio

 

 

Bottom Line

Agreed, Canadian crude prices are most likely to trade at a discount to WTI because of quality and pipeline issues. However, a string of positive updates associated with pipeline projects have been warmly received by investors.

The first piece of encouraging news was re-approval of the government-owned Trans Mountain pipeline expansion project with the hope that construction would kick off in certain areas before year-end. The controversial development, set to triple the original pipeline’s capacity to 890,000 barrels per day, will transport oil sands from Alberta to British Columbia's Pacific coast when it starts operating in 2022.

Secondly, TC Energy’s (TRP) Keystone XL pipeline, another contentious project, received green signal from Nebraska's highest court for the alternative route that passes through the state. The verdict brings the proposed Alberta-to-United States conduit a step closer to start construction.

Meanwhile, the official go-ahead for the much-awaited Kitimat mega LNG export facility is expected to be a game changer for the Canadian energy sector. The project will help ease the nation's gas oversupply while tapping into the growing demand for the commodity in Asia. Due to Canada’s proximity with the Asian markets along with robust natural gas production in British Columbia and Alberta, the nation is a much-preferred destination for the LNG export facilities. The startup of the Kitimat project is likely to unleash a new LNG wave in Canada.

Finally, the government-mandated production curtailments have come to the rescue of the distressed Canadian oil while priming the companies for shareholder friendly moves with the excess cash at their disposal.  

With the abovementioned catalysts set to provide near-term upside, we are presenting a stock with a Zacks Rank #2 (Buy) that is well positioned to gain amid the prevailing challenges. There are also three stocks with a Zacks Rank #3 (Hold) that investors may currently retain in their portfolio.

You can see the complete list of today’s Zacks #1 Rank stocks here.

Gran Tierra Energy Inc. (GTE): Gran Tierra Energy focuses on oil and natural gas exploration and production in Colombia. Over 60 days, the Calgary-headquartered company – carrying a Zacks Rank #2 – has seen the Zacks Consensus Estimate for 2019 surge 55.6%.

Price and Consensus: GTE

 

 

Canadian Natural Resources Limited (CNQ): This Calgary-based operator is one of the largest independent energy companies in Canada engaged in the exploration, development and production of oil and natural gas. Canadian Natural Resources, whose core operations are focused in Western Canada, the United Kingdom sector of the North Sea and offshore Africa, carries a Zacks Rank #3 and has an attractive expected earnings growth of 17.6% for this year.

Price and Consensus: CNQ

 

 

Baytex Energy Corp. (BTE): Baytex Energy is an intermediate explorer and producer with primary focus on the Western Canadian Sedimentary Basin and in the Eagle Ford in the United States. Over 60 days, the Calgary-headquartered company – carrying a Zacks Rank #3 – has seen the Zacks Consensus Estimate for 2019 surge 38.5%.

Price and Consensus: BTE

 

 

Crescent Point Energy Corp. (CPG): Crescent Point Energy’s operations are primarily concentrated in southwest and southeast Saskatchewan and Utah. The Calgary-based company carries a Zacks Rank #3 and has an attractive expected earnings growth of 42.4% for this year.

Price and Consensus: CPG

 

 

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TransCanada Corporation (TRP) : Free Stock Analysis Report
 
Royal Dutch Shell PLC (RDS.A) : Free Stock Analysis Report
 
Gran Tierra Energy Inc. (GTE) : Free Stock Analysis Report
 
Crescent Point Energy Corporation (CPG) : Free Stock Analysis Report
 
Canadian Natural Resources Limited (CNQ) : Free Stock Analysis Report
 
Baytex Energy Corp (BTE) : Free Stock Analysis Report
 
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