While commodity prices are expected to remain near the current levels, uncertainties related to slowing global economic growth and inflationary pressures have somewhat thwarted the Zacks Oil and Gas - Exploration and Production - Canadian industry’s positive momentum. Nevertheless, we think the space has fuel in the tank, especially for the operators that target growth opportunities and operating efficiency initiatives. We advise investors to focus on upstream firms like Canadian Natural Resources CNQ, Ovintiv OVV and Enerplus ERF that are expected to gain traction despite the existing headwinds.
About the Industry
The Zacks Oil and Gas - US E&P industry consists of companies primarily based in the domestic market, focused on the exploration and production (E&P) of oil and natural gas. These firms find hydrocarbon reservoirs, drill oil and gas wells, and produce and sell these materials to be refined later into products such as gasoline, fuel oil, distillate, etc. The economics of oil and gas supply and demand is the fundamental driver of this industry. In particular, a producer’s cash flow is primarily determined by the realized commodity prices. In fact, all E&P companies' results are vulnerable to historically volatile prices in the energy markets. A change in realizations affects their returns and causes them to alter their production growth rates. The E&P operators are also exposed to exploration risks where drilling results are comparatively uncertain.
3 Key Investing Trends to Watch in the Oil and Gas - Canadian E&P Industry
Backdrop of a Tightening Market: Earlier this year, the price of WCS crude — the Canadian benchmark — rose above $100 a barrel to reach its highest since 2008 on account of Russia’s launch of military operations in Ukraine. While oil has pulled back from those lofty levels, there is no sign of a quick resolution to the conflict, the risk of dwindling inventory and chances of the influential oil exporters’ group OPEC agreeing on a production curtailment. These give the commodity enough reasons to stay elevated in the near to medium term. What’s more, the commodity could spike further if the United States decides to tap Canada to replace its imports from Moscow that has been banned by the Biden administration. With even natural gas realizations remaining healthy amid the macro tailwinds, the E&P companies will greatly benefit for obvious reasons. Importantly, commodity prices appear to have entered a protracted period of stability at levels where the operators can generate free cash flow through their drilling activities to pay dividends or buy back their own stock.
Inflationary Cost Pressures: Canadian energy companies have been experiencing rising production costs in the form of increased expenses related to steel, manufactured goods, services and labor. The inflationary environment, together with supply-chain tightness, is not only pushing costs higher but also affecting their capital programs. Apart from being hard to ignore, escalation in expenses is also drowning out the benefits of higher commodity prices. In our view, the inflation-associated headwinds will continue to challenge growth and margin numbers, with little chance of a quick resolution. Finally, what this means is that the central bank will be persistent with its aggressive policy of raising rates to stem inflation, which may lead to a rough road for oil/gas equities. In particular, worries about weaker energy demand due to the threat of recession (spurred by rising interest rates and slowing consumer spending) might jeopardize the post-pandemic rebound in commodity consumption.
Lack of Pipeline Availability: Energy consultant IHS Markit sees oil production in Canada surging by some 900,000 barrels per day during the 2020-2030 period. Despite this impressive output growth, 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 an 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 more expensive to transport and refine. Following U.S. President Joe Biden’s revocation of TC Energy’s contentious Keystone XL pipeline and the company’s subsequent termination of the project, Canadian oil sands producers will have to wait a little longer for the takeaway capacity issue to be resolved.
Zacks Industry Rank Indicates Bearish Outlook
The Zacks Oil and Gas - Canadian E&P is a seven-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #197, which places it in the bottom 21% of some 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates challenging 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.
Despite the dim near-term prospects of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.
Industry Outperforms Sector & S&P 500
The Zacks Oil and Gas - Canadian E&P has fared better than the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.
The industry has gained 28.7% over this period compared with the broader sector’s increase of 26.3%. Meanwhile, the S&P 500 has lost 16.8%.
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 non-cash expenses.
On the basis of the trailing 12-month EV/EBITDA ratio, the industry is currently trading at 3.44X, significantly lower than the S&P 500’s 11.94X. It is also below the sector’s trailing-12-month EV/EBITDA of 3.69X.
Over the past five years, the industry has traded as high as 11.74X, as low as 2.81X, with a median of 5.34X, as the chart below shows.
Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio (Past Five Years)
Stocks to Watch For
Enerplus: An upstream operator, Enerplus focuses on Bakken and Three Forks formations in the Williston Basin in North Dakota, together with interests in the Marcellus Basin and waterflood projects in Canada. Banking on its low financial leverage and robust liquidity, ERF is in a pole position to take advantage of the sharply higher commodity prices.
Over 90 days, Enerplus has seen the Zacks Consensus Estimate for 2022 increase 7.8%. Sporting a market capitalization of around $3.9 billion, Zacks Rank #3 (Hold) ERF’s shares have surged 74% in a year. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Price and Consensus: ERF
Canadian Natural Resources: This Calgary-based energy major boasts a diversified portfolio of crude oil (heavy as well as light), natural gas, bitumen and synthetic crude oil. CNQ’s balanced and diverse production mix facilitates long-term value and reduces the risk profile, thereby lending its results a high level of stability. Lower capital expenditure needs, accretive acquisitions and improving operational efficiencies are the other positives in the Canadian Natural story, which allowed the company to generate a significant free cash flow of C$6.7 billion (post capital spending and dividends) in the first half of 2022.
Notably, CNQ beat the Zacks Consensus Estimate for earnings in each of the last four quarters. The company has a trailing four-quarter earnings surprise of 15.5%, on average. Canadian Natural, with a Zacks Rank of 3, has seen its shares gain 38.4% in a year.
Price and Consensus: CNQ
Ovintiv: An upstream operator, Ovintiv (formerly known as Encana) holds an attractive oil and gas production portfolio in three major North American unconventional basins: Montney, Anadarko and the Permian. Following the Newfield acquisition in 2019, the company has achieved higher liquids focus, greater scale and cost synergies. Ovintiv has also done a commendable job of cutting its expenses in a disciplined manner, which should boost free cash flow generation.
Headquartered in Denver, CO, Ovintiv has a projected earnings growth rate of 75.7% for this year. OVV’s expected EPS growth rate for three to five years is currently 46.7%, which compares favorably with the industry's growth rate of 29.4%. Ovintiv, a Zacks Rank #3 stock, has seen its shares go up 30.9% in a year.
Price and Consensus: OVV
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