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Near-Term Outlook Positive for Oil & Gas Canadian E&P Industry

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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:

•    Oil has clawed back some of the ground lost in a sharp selloff associated with the coronavirus-induced demand destruction for the fuel. Likewise, Western Canadian Select ("WCS") is now on an upswing, with the benchmark price for Alberta oil sands back at around $35 a barrel. The contract’s steady uptick is an indication of a tighter market as easing lockdown measures improve the demand outlook amid massive production cuts by the OPEC+ group. Adding to the supply reductions, top Canadian and U.S. producers have all slashed production.

•    The positive final investment decision for Royal Dutch Shell’s (RDS.A - Free Report) LNG Canada project (in October 2018) 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.

•    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.

Zacks Industry Rank Indicates Bullish Outlook

The Zacks Oil and Gas - Canadian E&P is a 6-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #87, which places it in the top 34% 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 bright 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.

Now let’s take a look at the industry’s shareholder returns and current valuation.

Industry Mixed on Stock Market Performance

The Zacks Oil and Gas - Canadian E&P fared better than the broader Zacks Oil - Energy Sector but has lagged the Zacks S&P 500 composite over the past year.

The industry has lost 24.1% over this period compared to the S&P 500’s rally of 12.6% and broader sector’s decrease of 25.7%.

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 3.74X, significantly lower than the S&P 500’s 11.82X. It is also below the sector’s trailing-12-month EV/EBITDA of 4.37X.

Over the past five years, the industry has traded as high as 17.93X, as low as 2.72X, with a median of 7.59X, 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. But the sentiment seems to have flipped from bearish to bullish in the last few weeks as tailwinds for the commodity strengthen.

It seems that crude’s worst losses are in the rear view mirror with signs of gradual rebalancing. The OPEC+ group has started to withhold output by almost 10 million barrels per day – the largest in history – from May 1, which has tackled a global supply glut and lifted a barrel of crude considerably. Finally, greater financial discipline practiced by the energy companies has raised expectations that supply growth could slow down sooner than later even as fuel demand picks up on easing lockdown measures.

Meanwhile, Alberta government’s newly announced financial support to TC Energy’s (TRP - Free Report) flagship infrastructure project – Keystone XL – has been warmly received by investors. In a rare instance of providing funds for an oil pipeline, Alberta's United Conservative government is set to take an equity interest of $1.1 billion and authorize a $4.2-billion loan guarantee to help smooth out the path forward for the much-delayed project.

With the above-mentioned catalysts set to provide near-term upside, we are presenting three stocks with a Zacks Rank #3 (Hold) that investors may currently retain in their portfolio. These are Enerplus Corporation (ERF - Free Report) , Ovintiv Inc. (OVV - Free Report) and Canadian Natural Resources Limited (CNQ - Free Report) .

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

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Each was hand-picked by a Zacks expert as the #1 favorite stock to gain +100% or more in 2020. Each comes from a different sector and has unique qualities and catalysts that could fuel exceptional growth.

Most of the stocks in this report are flying under Wall Street radar, which provides a great opportunity to get in on the ground floor.

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