Pointing to “growing evidence” of multiple expansion following recent share price outperformance, Desjardins Securities analyst Chris MacCulloch said he’s becoming “more cautious” on the energy sector, particularly on the oil side, expressing a preference for natural gas–weighted equities.
“Let’s cut to the chase — Canadian oil & gas equities have been on a stick since the beginning of the summer, coinciding with the movement in global oil prices which has propelled WTI back up to approximately US$90 per barrel. “While we largely ascribe surging oil prices to deep Russo-Saudi supply cuts which have been extended until year-end, there is also growing optimism that a much anticipated global economic downturn may not prove as corrosive for fuel demand as previously feared. When combined with relatively tight differentials, a lethargic loonie and strengthening balance sheets triggering increased FCF allocation to capital returns, there has arguably never been a better time to be a Canadian oil producer, let alone a refiner given the recent surge in crack spreads. Meanwhile, natural gas producers have survived what was widely expected to be a miserable summer for AECO prices largely unscathed, and with clear visibility to much stronger 2024–25 cash flows given the contango in the futures strip while LNG Canada is coming into view.
“Here comes the ‘but’. Although industry balance sheets have improved markedly in recent years, which has effectively removed downside tail risk from most stocks, we are beginning to see evidence of multiple expansion in Canadian oil & gas equities (see Exhibit 10), along with a contraction in FCF yields. Based on Bloomberg consensus estimates, the one-year rolling forward sector EV/DACF multiple recently eclipsed its five-year average while the FCF yield has dipped below at 5.3 times and 10.8 per cent, respectively. Granted, both metrics remain highly attractive within the context of longer-term trends; we highlight that sector EV/DACF multiples routinely averaged closer to 8 times in the preceding five years (2013–18), a period during which FCF was a foreign concept for most producers!”
In a research report released Monday, Mr. MacCulloch said the recent multiple expansion “warrants at least some degree of investor caution given the inherent volatility in commodity prices.”
“We do not believe it’s a stretch to suggest that most of the easy gains in Canadian oil & gas equities have now occurred following a 3.5-year period of supernormal performance, although it’s a deeply unpopular view in some quarters,” he added. “Barring another sharp leg-up in commodity prices, which may be forthcoming on the natural gas side, investors need to become more discriminating with respect to security selection. Implied returns to target have thinned for all names under coverage in recent months, although we still see deep value in select corners of the sector.”
Citing limited potential returns, the analyst downgraded his recommendations for the two top-performing stocks in his coverage universe on Monday:
* Athabasca Oil Corp. to “hold” from “buy” with a $4.50 target (unchanged). The average target on the Street is $4.39, according to Refinitiv data.
“The stock has been on a run for the ages, racking up a 52.3-per-cent return since late June — the best-performing name in the Desjardins E&P coverage universe and massively outpacing the S&P/TSX Capped Energy Index (up 25.0 per cent, before factoring in dividends),” he said. “Naturally, with a strengthened balance sheet which was further bolstered by the completed disposition of some of the company’s non-core Montney and Duvernay assets—not to mention renewed strength in Canadian heavy oil prices prior to the upcoming commissioning of the TransMountain Expansion (TMX) project—the corporate outlook has improved in recent months. However, valuation is also beginning to stretch with a 2024 strip EV/DACF multiple of 3.7 times, which screens toward the upper end of the small- and mid-cap Canadian oil space. Moreover, there are lingering questions surrounding the company’s eventual plans to increase Leismer production to the 40,000 bbl/d regulatory-approved level, which would require a significant capital outlay, potentially necessitating alternative financing and/or a slowdown in the FCF allocation toward share buybacks. That said, our downgrade should by no means be construed as a pessimistic tone on the company, which we still believe has a very promising future as investor focus begins shifting back to the Canadian oil sands. Simply put, we see better opportunities for short- and medium-term upside elsewhere in our coverage universe following a phenomenal run in the stock, and we believe investors should look to put new money to work in other names.”
* Suncor Energy Inc. to “hold” from “buy” with a $49 target, up from $48. The average is $50.94.
“We are downgrading SU ... reflecting limited return potential to our revised $49.00 target price (from $48.00) and our more cautious outlook on forward M&A activity,” he said. “The stock has been on an absolute tear since the company reported 2Q23 financial results in mid-August — trading up 10 per cent — the second-best performance in the Desjardins E&P coverage universe. With CEO Rich Kruger now at the helm for roughly six months, SU has trimmed overhead costs while also completing its portfolio clean-up of non-core assets following the recent UK North Sea disposition. More importantly, the company appears to have taken the necessary steps to improve operational performance following a steady string of disappointing results in recent years and is also benefiting from a commodity price tailwind on the back of strengthening Canadian heavy oil prices and crack spreads. However, ConocoPhillips’ recent consolidation of Surmont has arguably set the company’s Base Mine replacement plans back by removing an attractive potential substitute as the asset approaches end of life in the mid-2030s, with production declines expected to commence later this decade. While consolidation of TotalEnergies Canada’s remaining 31.23-per-cent non-operated WI in Fort Hills appears to be a foregone conclusion at this point, most likely prior to year-end according to corporate guidance, we still believe that SU will need to explore other M&A opportunities in the absence of brownfield expansions at Firebag, MacKay River or Fort Hills to replace Base Mine volumes. Following the recent pickup in commodity prices, our perception is that any strategic transaction will now come with a richer implied valuation, particularly after the removal of a major piece from the oil sands chess board (ie Surmont). In summary, we believe that many of the near-term catalysts for the story have now played out and that other Canadian large caps offer superior near-term upside potential.”
Mr. MacCulloch also made a series of target changes to stocks in his coverage universe. For large caps, his changes were:
- ARC Resources Ltd. (“buy”) to $26 from $25. Average: $23.91.
- Canadian Natural Resources Ltd. ( “buy”) to $96 from $95. Average: $92.35.
- Cenovus Energy Inc. ( “buy”) to $33.50 from $31. Average: $30.47.
- Imperial Oil Ltd. (“hold”) to $83 from $76. Average: $80.71.
- Tourmaline Oil Corp. (, “buy”) to $79 from $77. Average: $81.19.
For dividend-paying stocks, his changes are:
- Enerplus Corp. ( “buy”) to $23 from $21. Average: $23.97.
- Headwater Exploration Inc. ( “buy”) to $9 from $9.25. Average: $9.28.
- Peyto Exploration & Development Corp. ( “hold”) to $13.50 from $13. Average: $15.25.
- Tamarack Valley Energy Ltd. ( “buy”) to $5.75 from $5.50. Average: $5.83.
- Vermilion Energy Inc. ( “hold”) to $23.50 from $22. Average: $25.04.
- Whitecap Resources Inc. ( “buy”) to $13.50 from $12.75. Average: $13.81.
“Our top picks are CVE (integrated oil), ARX (large-cap natural gas), TVE (mid-cap oil), AAV (small-cap natural gas), TPZ (royalty) and SDE (special situation),” he said.