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On Jun 28, 2013, we upgraded independent oil and gas explorer Canadian Natural Resources Ltd. (CNQ - Analyst Report) to Neutral from Underperform. Our new investment thesis is supported by a Zacks Rank #3 (Hold).

Why the Upgrade?

The company’s large, diversified oil and gas asset bases, together with international exposure and a well-balanced blend of conventional and unconventional prospects, provides a buffer against uncertainties in the sector. Other positives for CNQ include its active hedging policy, competitive cost structure, strong balance sheet and robust free cash flow.

Detailed Analysis

Calgary, Alberta-based CNQ has a broad portfolio of low-risk exploration and development projects that yield long-term volume growth at above-average rates. In particular, the company’s strong, balanced and diverse asset portfolio, combined with its focus on low cost operations, allowed it to generate substantial free cash flow even in a low price environment. Additionally, with most of CNQ’s production generated from North America, it escapes the political risk associated with operations in unstable countries.

Additionally, CNQ displays a healthy financial position, reflected by a low debt-to-capitalization ratio of 27.7%, making the company less susceptible to financial risk. Backed by this strength, management has hiked dividend for 13 consecutive years with a compounded annual growth rate of 21%.

However, we think that these factors are adequately reflected in the present valuation, leaving little room for meaningful upside from current levels. CNQ’s exposure to the inherently cyclical and volatile exploration and production (E&P) sector offsets these strengths and remains a key area of concern, in our view. The stock has also been held back by operational challenges, continued volatility in natural gas prices and a fresh round of cost inflation in the oil sands regions.

Stocks That Warrant a Look

While we expect CNQ to perform in line with its peers and industry levels in the coming months and advice investors to wait for a better entry point before accumulating units, one can look at ARC Resources Ltd. (AETUF), Canadian Oil Sands Ltd. (COSWF) and Enerplus Corp. (ERF - Snapshot Report) as good buying opportunities. These Canadian upstream energy operators – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with potential to rise significantly from current levels.         

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