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Oil and Gas - Canadian E&P Stock Outlook: Signs of Tailwind

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While oil production is surging in Canada, the country's exploration and production (E&P) 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 bottlenecks.

This has forced producers to give away their products in the United States – Canada’s major market – at a discounted rate. In fact, the price gap between Alberta’s Western Canada Select and the New York-traded West Texas Intermediate recently rose to around $30 per barrel – the most in more than five years.

However, the encouraging progress on a number of crucial infrastructure projects and the broadly improving Western Canadian Select prices should benefit heavy oil producers and cause an inflection in the E&P space over time. A reduction in heavy oil coming out of Mexico and Venezuela is also expected to narrow the divergence between the two benchmarks.

Even within Canada, instead of investing in risky and costly oil sands projects, the companies are now looking to pump resources into two of the popular shale plays of the company — Duvernay in central Alberta and Montney in east central British Columbia.

Finally, throughout the downturn, Canadian energy producers, just like their American counterparts, worked tirelessly to cut costs to a bare minimum and look for innovative ways to churn out more oil and gas. And they managed to do just that by improving drilling techniques and extracting favorable terms from the beleaguered service producers. Moreover, driven by operational efficiencies, these entities have been able to reduce unit costs and live within their cash flows – priming them for upward pressure on both revenues and earnings.

Industry Underperforms on Shareholder Returns

Looking at shareholder returns over the past year, it is quite apparent that investors are not too confident about the industry’s prospects. Despite improving commodity prices and the subsequent strength in profit growth, the space still has a lot of uncertainty surrounding Canada’s regulatory/environmental policy framework, limited pipeline infrastructure, and the resulting large discount for crude priced at Alberta’s Western Canada Select compared to the New York-traded West Texas Intermediate oil benchmark. 

The Zacks Oil and Gas - Exploration and Production - Canadian industry, part of the broader Zacks Oil and Energy Sector, has underperformed the S&P 500 and has barely matched its own sector over the past year. While the stocks in this industry have collectively gained 13.3% - almost identical to the Zacks Oil and Energy Sector’s 13.2%, the Zacks S&P 500 Composite rallied 16.8%.

One-Year Price Performance

 

The Group Remains a Bargain Opportunity for Investors

Since upstream-focused 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.

Thanks to the industry underperformance over the past year, the valuation picture appears pretty attractive, in comparison to the market at large. The industry currently has a trailing 12-month EV/EBITDA ratio of 6.30, at a significant discount to the S&P 500’s EV/EBITDA ratio 11.57. Moreover, the group’s valuation leaves plenty of room for upside when compared with its highest level of 11.11 over the 12-month period.

Enterprise Value/EBITDA Ratio (TTM)

 

 

As the industry’s valuation multiple is closely corelated with crude prices, comparing the group’s EV/EBITDA ratio with that of its border sector may make better sense to many investors.

The parameter shows that the group’s EV/EBITDA ratio – at 6.30 – is slightly above that of its broader sector’s 6.14. While this might suggest little room to run further, investors should note that the industry has historically traded at a hefty premium to its sector.  

Enterprise Value/EBITDA Ratio (TTM)

 

 

Prospects Look Bright on Robust Earnings Outlook

With the OPEC meeting essentially putting a floor beneath crude, the commodity should continue to trade at a price that is well above the breakeven level for producers. Moreover, the tough three years for the industry forced operators to make cost control their primary focus.

And now, most of the companies are able to cover their investment and payouts with cash from operations – something that investors desperately want. In fact, riding on improving commodity prices, a stronger production outlook and healthier cash flows, the Canadian exploration and production stocks should continue generating positive shareholder returns in the near future.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. While the ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences its stock performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it as well as the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019 while the light blue line represents the same for 2018.

Price and Consensus: Zacks Canadian E&P Industry

 

 

This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the 99 cents EPS estimate for the industry for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks Canadian E&P industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry’s earnings per share for 2018 but how this estimate has evolved recently.  

Current Fiscal Year EPS Estimate Revisions

 

 

As you can see here, the EPS estimate for 2018 is up from 79 cents at the end of March and 75 cents this time last year. In other words, the sell-side analysts covering the companies in the Zacks Canadian E&P industry have been steadily raising their estimates.

Zacks Industry Rank Confirms Growth Outlook

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued outperformance in the near term.

The Zacks Canadian E&P Industry currently carries a Zacks Industry Rank #59, placing it at the top 23% of more than 250 Zacks industries. 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.

In fact, the basis of this bullish outlook could be the recovery in top line that Canadian oil producers have been showing since the beginning of 2017.

Revenues: Zacks Canadian E&P industry

 

 

Another important indication of bright future prospect is the improvement in the group’s free cash flow, which is a key metric for evaluating upstream oil and gas stocks. It’s quite clear that the companies are generating enough cash to pay off debt along with funding capex and dividend payments.

Free Cash Flow: Zacks Canadian E&P industry

 

 

Bottom Line

Crude has been crawling its way back up after falling sharply from $100 a barrel in 2014 and a low of $26 in 2016. Supply-side shocks out of Iran and Venezuela in the face of growing global consumption levels — especially in emerging markets such as China and India — have put the oil market in a fundamentally tight spot. This robust backdrop, which is expected to strengthen over the course of this year, has breathed life back into the sector.

Agreed, the crude pricing strength is not likely to lead to a proportionate increase in Canadian oil realizations because of the issues discussed above. However, as part of a strategic shift, Canadian oil companies are now looking to pump resources into two of the popular shale plays of the country — Duvernay in central Alberta and Montney – instead of investing in risky and costly oil sands projects.

The gradual uptick in crude prices along with efficient strides adopted by the companies during the slump are now encouraging producers to rev up development. As a result, most Canadian upstream players are off to a strong start in 2018, exceeding their production targets through a combination of a high level of operational execution, lower completion cycle times and impressive cost reductions.

Importantly, this provides investors with an excellent chance to accumulate some quality Canadian E&P names – more so the ones with strong earnings outlook.

Below are three stocks with positive earnings estimate revisions and a bullish Zacks Rank.

Canadian Natural Resources Ltd. (CNQ - Free Report) is one of the largest independent energy companies in the country engaged in the exploration, development and production of oil and natural gas in Western Canada, the United Kingdom sector of the North Sea and offshore Africa.The stock of this Calgary-based explorer has gained 9.4% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 19.3% upward over the last 60 days. Canadian Natural Resources flaunts a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

 

Price and Consensus: CNQ

 

Baytex Energy Corporation (BTE - Free Report) is an intermediate explorer and producer with primary focus on the Western Canadian Sedimentary Basin and in the Eagle Ford in the United States.The stock of this Calgary-based explorer has gained 9.7% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 56% upward over the last 60 days. Baytex Energy carries a Zacks Rank of 2.

Price and Consensus: BTE

 

TransGlobe Energy Corporation (TGA - Free Report) is an oil and gas exploration and production company with operations primarily focused in Canada and Egypt.The stock of this explorer, also based in Calgary, has gained 155.9% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised significantly upward (from 2 cents to 51 cents) over the last 60 days. TransGlobe Energy also has a Zacks Rank #2.

Price and Consensus: TGA

 

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