Desjardins Securities analyst Chris MacCulloch admits the recent strong run in Canadian oil & gas equities in has defied his “wildest expectations.”
“After a slow start to the year, Canadian oil & gas equities are seemingly moving from strength to strength, posting the best sector performance on the TSX (by far) on the back of rising oil prices and TMX linefill, which has propelled large-cap integrated and oil sandsweighted stocks toward new heights,” he said. “Perhaps the only thing working against the sector right now is natural gas prices, but even there, the market is largely inclined to look through near-term weakness toward brighter days ahead with upcoming commissioning of the first phase of LNG Canada expected to begin later this year.
“While fully acknowledging that sector balance sheets and capital return frameworks have never been healthier or more generous to shareholders, we are growing more cautious on valuations after an extended period of outperformance, which has stretched industry multiples to a five-year high (after correcting for the abnormalities of the COVID-19 pandemic). Put another way, both the industry FCF yield and the equity risk premium for holding Canadian oil & equities has now returned to pre-pandemic levels, which should at the very least be a source of caution.”
As the sector heads into earnings season, Mr. MacCulloch thinks the primary driver of further sector outperformance will be commodity prices, however he emphasizes “the forecasting of which has been, and will remain, a mug’s game.”
“But for what it’s worth, we have walked up our 2024 oil price forecast by US$10 per barrel while trimming our 2025 deck by US$5/bbl (to US$70/bbl WTI),” he said. “On the natural gas side, we have trimmed our 2025 NYMEX and AECO price forecast to US$3.50/mcf and C$3.50/mcf, respectively. Meanwhile, we have expanded target multiples for every producer under coverage, which is partially a reflection of the aforementioned shift in sector multiples. However, there is no question that returns to target are thinning, as reflected in our three downgrades. In our view, we are likely entering the late innings of what has been a phenomenal run for the ages in Canadian oil & gas equities over the last four years coming out of the depths of the pandemic, particularly among large-cap integrated and oil sandsweighted stocks, where we are struggling to see attractive opportunities. To that end, we believe investors should be rotating exposure down cap and toward natural gasweighted stocks, where we see greater opportunities for alpha generation; however, we’ll be the first to admit that the next 3–6 months will be a challenging period for the latter given current market oversupply. Tread carefully.”
Citing limited potential returns to his targets, Mr. MacCulloch downgraded three stocks on Tuesday:
* Athabasca Oil Corp. to “hold” from “buy” with a $5.75 target (unchanged). The average on the Street is $6.06.
Analyst: “Although we remain optimistic on the longer-term corporate outlook, including the recent emergence of Duvernay Energy Corporation, corporate cash flow is still primarily driven by heavy oil production, the value of which has appreciated considerably in recent weeks with WCS differentials tightening as TMX linefill commences. However, the stock has been one of the best-performing names in the sector since we upgraded it last December, and we are increasingly cautious that most of the upside has been fully discounted into the current valuation, which could result in downside if further narrowing of WCS differentials fails to materialize. Moreover, we expect oil prices to correct from current levels moving into 2025, which would disproportionately impact ATH relative to peers to the extent that it retains the highest cash flow sensitivity (to oil prices) in the Desjardins E&P coverage universe. That said, the company has done a commendable job fortifying the balance sheet in recent years, even while pursuing an aggressive share buyback program, which should help put a floor under the stock in a downside scenario.”
* Canadian Natural Resources Ltd. to “hold” from “buy” with a $110 target, rising from $104. Average: $110.87.
Analyst: “The stock has consistently screened among the top-performing companies in recent months as generalist and international investors flock to the story for commodity price exposure from one of the best-run companies in the Canadian energy sector, with an unparalleled track record of operational execution and disciplined capital allocation. As a result, the valuation has begun to stretch beyond our comfort zone, which limits the potential for further upside, from our perspective. And while acknowledging that CNQ will likely remain the ‘go to’ name for generalists, we believe this also opens the door for capital flight if oil prices deteriorate as we anticipate heading into 2025. Meanwhile, we see limited near-term catalysts for the story both from an M&A perspective given renewed strength in sector valuations and from a return-of-capital perspective after the company’s recent achievement of its $10-billion net debt target in February, which received universal market applause. That said, we have every confidence that CNQ will continue delivering superior operational performance and we would look for opportunities to build positions during periods of weakness”
* Spartan Delta Corp. to “hold” from “buy” with a $4.50 target (unchanged). Average: $4.90.
Analyst: “Although the stock languished in 2H23 following its transformative disposition of the Alberta Montney assets, it has posted a vigorous recovery through the opening months of 2024, trading up more than 40 per cent to date this year as the best-performing name in the Desjardins E&P coverage universe. However, we remain cautious on the company’s nearterm cash flow generation capability given its elevated exposure to the AECO natural gas market, where we expect pricing to remain subdued through the summer months. We are also taking a ‘wait and see’ approach with respect to the West Shale Basin Duvernay assets, development plans for which are expected to be unveiled later this spring on the back of additional land acquisitions, potentially including the former Bonavista Energy Duvernay rights from TOU that are currently being marketed in a public process. Historically, the play has struggled to compete for capital given elevated well costs, although we understand that the company (and some of its peers) has made significant advances on this front through refinements in drilling and completion techniques. We will also be the first to acknowledge the management team’s previous technical prowess unlocking value from the Alberta Montney oil window, the Cardium and southeast Saskatchewan conventional oil plays (among others). Simply put, we need to see more results before we start ascribing significant value to the Duvernay assets.”
For large-cap stocks, he made these target changes
- Cenovus Energy Inc. ( “buy”) to $31.50 from $29.50. Average: $32.92.
- Imperial Oil Ltd. ( “hold”) to $92 from $88. Average: $95.67.
- Suncor Energy Inc. ( “hold”) to $54 from $48.50. Average: $55.06.
- Tourmaline Oil Corp. ( “buy”) to $74 from $75. Average: $76.94.
For dividend-paying stocks, his changes are:
- Crescent Point Energy Corp. ( “buy”) to $14 from $12.50. Average: $14.18.
- Enerplus Corp. ( “tender”) to $20 from $19.25. Average: $24.94.
- Peyto Exploration & Development Corp. ( “hold”) to $13.50 from $14. Average: $17.
- Pine Cliff Energy Ltd. ( “buy”) to $1.20 from $1.25. Average: $1.51.
- Vermilion Energy Inc. (“buy”) to $21 from $20. Average: $20.83.
“From a high level, we believe investors should begin rotating exposure down cap and toward natural gasweighted stocks, where we see greater opportunities for alpha generation. Our top picks are CVE (large-cap oil), TOU (large-cap natural gas), CPG (small/midcap oil), AAV (small/mid-cap natural gas), VET (special situation) and FRU (royalty),” he concluded.