Chicago, IL – March 12, 2024 – Today, Zacks Equity Research discusses Canadian Natural Resources Ltd. CNQ, Ovintiv Inc. OVV and Baytex Energy Corp. BTE.
Link: https://www.zacks.com/commentary/2238666/3-stocks-in-the-canadian-upstream-industry-worth-some-thought
Several factors have dimmed the sentiment in the energy market, impacting the Zacks Oil and Gas - Exploration and Production - Canadian industry. These factors include worries regarding global economic growth and uncertainties surrounding demand forecasts. A notable increase in fuel inventories, coupled with OPEC+'s extension of production cuts lacking any positive surprises, has overshadowed the outlook for energy demand.
Moreover, concerns persist about sluggish demand in China. The natural gas sector has also been affected by the broader market downturn, experiencing significant declines year to date. Despite macroeconomic challenges causing uncertainty in demand, the industry demonstrates resilience, especially for companies prioritizing growth and operational efficiency. Canadian Natural Resources Ltd., Ovintiv Inc. and Baytex Energy Corp. emerge as noteworthy options for investors navigating this complex landscape, offering potential amid prevailing economic challenges.
The Zacks Oil and Gas - Canadian E&P industry consists of companies primarily based in Canada, 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 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. E&P operators are also exposed to exploration risks where drilling results are comparatively uncertain.
Oil, Gas Markets Struggle to Absorb Supply Glut: WCS crude, the Canadian benchmark, is currently trading under $65 per barrel due to a substantial build in fuel inventories and increased production. Despite OPEC+ announcing an extension of voluntary production cuts for another three months, it has failed to affect oil prices in a significant way. China's economic challenges added to the gloom, affecting global demand forecasts.
Shifting focus to natural gas, the commodity, which had slumped to a 25-year low in June 2020 but reached $10 per MMBtu in August 2022, is now trading below $2. This decline is attributed to heightened production levels and lackluster weather-related demand.
Focused on Cost-Cutting Initiatives: The Canadian energy companies have changed their approach to spending capital. Over the past few years, producers have 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 providers.
Moreover, driven by operational efficiencies, most E&P operators have been able to reduce unit costs, while the coronavirus-induced collapse in crude forced them to adopt a more disciplined approach to spending capital. These actions are expected to preserve cash flow and support balance sheet strength.
Insufficient Pipeline Capacity: According to energy consultant IHS Markit, oil production in Canada is projected to surge by approximately 900,000 barrels per day between 2020 and 2030. Despite this promising growth forecast, the country's exploration and production sector has fallen out of favor, largely due to the shortage of pipelines.
In essence, the construction of pipelines in Canada has not kept pace with the increasing volumes of domestic crude oil, particularly the heavier sour variety extracted from the oil sands, resulting in a bottleneck in infrastructure. Consequently, producers have been compelled to sell their products to the United States, Canada's primary market, at discounted rates. With the cancellation of TC Energy's controversial Keystone XL pipeline following U.S. President Joe Biden's revocation, Canadian oil sands producers will face further delays in resolving the takeaway capacity issue.
The Zacks Oil and Gas - Canadian E&P is a 10-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #158, which places it in the bottom 37% 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 fairly dull 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.
The industry's position in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are becoming pessimistic about this group's earnings growth potential. While the industry's earnings estimate for 2024 has gone down 21.6% in the past year, the same for 2025 has fallen 6.4% over the said timeframe.
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.
The Zacks Oil and Gas - Canadian E&P has fared better than the broader Zacks Oil - Energy sector over the past year but has underperformed the Zacks S&P 500 composite over the same period.
The industry has gone up 15.7% over this period compared with the broader sector's increase of 6.1% and the S&P 500's gain of 33.3%.
Since oil and gas companies are debt-laden, it makes sense to value them based on the Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization (EV/EBITDA) 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 4.80X, significantly lower than the S&P 500's 14.73X. It is, however, above the sector's trailing-12-month EV/EBITDA of 3.76X.
Over the past five years, the industry has traded as high as 11.60X, as low as 2.51X, with a median of 4.58X.
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 risk profile, thereby lending its results a high level of stability. Lower capital expenditure needs, accretive acquisitions and improving operational efficiencies have been the other positives in Canadian Natural's story, which allowed it to generate a significant free cash flow of C$6.9 billion (post capital spending and dividends) in 2023.
CNQ beat the Zacks Consensus Estimate for earnings in three of the last four quarters and missed in the other. It has a trailing four-quarter earnings surprise of roughly 7%, on average. Canadian Natural shares have gained 31.7% in a year. The stock carries a Zacks Rank #3 (Hold). You can see the complete list of today's Zacks #1 Rank stocks here.
Ovintiv: Ovintiv is an independent E&P operator with 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 a higher liquids focus, greater scale and cost synergies. Ovintiv has done a commendable job of cutting its expenses in a Disciplined manner, which should boost free cash flow generation. Ovintiv's cash flows will also receive downside protection from attractive oil and gas hedges.
Ovintiv beat the Zacks Consensus Estimate for earnings in two of the last four quarters and missed in the other two. It has a trailing four-quarter earnings surprise of roughly 5.6%, on average. The #3 Ranked company's Value and Growth Score of A each help it to round out with a VGM Score of A. With a market capitalization of around $13.3 billion, OVV has increased 31.5% in a year.
Baytex Energy: An energy producer based in Western Canada, Baytex focuses on a high-quality and diversified oil portfolio across multiple plays, spanning Peace River, Duvernay, Lloydminster and Viking. The company is also active in the Eagle Ford shale. Banking on its strong execution and disciplined capital allocation, BTE is on track to generate substantial free cash flow in this commodity upcycle. Baytex is also relentlessly working to improve its leverage ratios and enhance shareholder returns.
Headquartered in Calgary, Alberta, BTE has a trailing four-quarter earnings surprise of roughly 44.4%, on average. The Zacks Consensus Estimate for the company's 2024 earnings indicates 4.1% year-over-year growth. BTE, carrying a Zacks Rank #3, has seen its stock go down 7.8% in a year.
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