Two oil patch heavyweights now a bargain

Plunging petroleum prices may have chilled the oil patch and the halls of government alike. But they’ve given investors a heaven-sent opportunity to scoop up some best-of-breed outfits in the energy sector.

“Don’t believe me?” asks Elvis Picardo, vice president, research, as well as portfolio manager at Vancouver-based Global Securities Corp. Then, consider that although prices for Brent crude oil have fallen more than 25 per cent from their June highs, the shares of many oil and gas producers have fallen twice as much.

Indeed, some of the biggest names in Canadian energy are now trading at attractive valuations. And their combination of growth potential and relative safety make them very appealing.

Although crude oil had been drifting lower over the summer, it took a real tumble starting in September, spurred by lower demand, as well as soaring supply, thanks to record production of U.S. shale oil.

Premium sputtered

Then, too, the big risk premium that had been built into oil prices sputtered by late summer, as fears subsided that Mideast upheaval would disrupt supply.

In mid-October, the International Energy Agency predicted that 2014 oil consumption would fall by 200,000 barrels to 92.4 million barrels a day, on expectations of lower economic growth. It also said that total global supply in September likely rose to 93.8 million barrels — a year-over-year increase of three per cent, or 2.8 million barrels a day, thanks to higher overall production.

But the agency sees global demand increasing by 1.2 per cent to 93.5 million barrels, as the global economy improves. Over the long-term, the International Energy Agency expects global demand to average increases of 1.3 per cent to 2019, eventually hitting 100 million barrels a day.

And although the International Monetary Fund recently cut its estimate for worldwide growth in 2015 to 3.8 per cent, this is still the fastest rate of global expansion since 2011.

Admittedly, this is a relatively healthy picture. But global supply capacity is also expected to increase by 6.3 per cent to 105 million barrels a day by 2019.

Nonetheless, this long-term supply is far from assured, since a big chunk of crude oil comes from war-torn parts of the world. For example, over the past year alone, says the IMF, disruptions in oil supply topped more than 3 million barrels a day. Not surprisingly, the biggest disruptions were in Iraq, Libya, Syria and, because of sanctions, Iran.

Prices could spike

And although oil is once again flowing from most of these countries, any sudden spike in, say, terrorism could push prices up.

True, the plunge in petroleum prices had many market participants thinking that it could take years for oil to bounce back. But several analysts now expect a rebound to occur sooner than that, perhaps as early as next year.

These folks reason that because a lot of oil represents high-cost output, a prolonged period of low prices could lead to production cutbacks, along with the cancellation of energy projects. In fact, Abdallah el-Badri, secretary-general of the Organization of Petroleum Exporting Countries, says that at current prices, up to 50 per cent of tight oil from shale deposits is now at risk.

Moreover, the marginal cost of producing oil has more than tripled in 2013 to US$107 from $30 a barrel in 2001, says Sanford Bernstein, a New York-based asset management firm.

But judging from the steep decline in their share prices, energy producers are now pricing in a much more dismal scenario. And prices have fallen. For example, the TSX Energy index has slumped substantially since Sept. 3, when the S&P/TSX Composite Index hit a record high.

Gain largely wiped out

As a result, the gain posted by the energy index has almost vanished, with the group now barely holding onto positive territory.

But folks who are willing to wait out the storm would do well to consider such stalwarts as Suncor Energy Inc. (SU—TSX; SU–NYSE) and Crescent Point Energy Corp. (CPG—TSX; CPG–NYSE). Neither outfit has emerged unscathed from the drop in petroleum prices since hitting their multi-year highs on June 16.

Of course, Suncor is a name that needs no introduction, given its big footprint in the Alberta tarsands. And oil’s climb-down has focused attention on the high costs of tarsands extraction — a business that could be in trouble should petroleum prices stay low.

But Suncor, because of its integrated business model, is somewhat insulated from this concern. Indeed, the scale of its tarsands operations gives it a lower break-even point than its smaller rivals, while its refining business enables it to capture higher Brent-based pricing on most of its output.

For its most recent reporting period, Suncor saw operating earnings fall 8.4 per cent year-over-year to $1.3 billion or $0.89 a share. The slide reflected lower oil prices, as well as lower output in its exploration and production business.

Cash flow also fell

Not surprisingly, operating cash flow was also down, falling 9.8 per cent to $2.28 billion or $1.56 a share. Still, because of record tarsands output of 411,700 barrels a day, the company was able to cut its cash operating costs to $31.10 a barrel.

In the meantime, Suncor’s solid balance sheet, along with its strong cash flow, should help it weather any prolonged volatility in oil prices.

Moreover, the company is stockholder-friendly, having raised its dividend at a compound annual growth rate of 30 per cent over the past five years. In fact, it announced the most recent increase on July 30 to a quarterly dividend of $0.28 a share.

Now, let’s go back to Crescent Point, the seventh-biggest energy producer in Canada, as well as a stock we added to our model portfolio in the first week of October.

Crescent Point offers above-average, sustainable dividends and long-term prospects for growth.

It has managed to log solid growth over the past decade, thanks to its three-pronged strategy of buying and then developing large, high-quality, resource-in-place assets, while managing risk through conservative hedging.

History well-known

In addition, Crescent Point has a history of making accretive acquisitions, the latest being its purchase of conventional oil assets in early September from Calgary-based Lightstream Resources Ltd. (LTS–TSX; LSTMF—OTC).

Upon closing the deal, Crescent Point boosted its 2014 estimates of exit production, average daily output, as well as funds from operation which is now expected to grow six per cent to $2.6 billion, or $6.13 a share.

Since late June, the company has paid monthly dividends of $0.23 a share. But in spite of that, Crescent Point’s payout ratio has steadily fallen, to 45 per cent in the second quarter — the lowest in its history — from 75 per cent in 2010.

Moreover, with a ratio of net debt to 12-month cash flow (estimated) of roughly 1.1, the company’s balance sheet is strong.

And thanks to its hedging program, Crescent Point has cut its exposure to oil price ups and downs. In fact, as of August 5, it had hedged 62 per cent of its production for the rest of 2014, 38 per cent for 2015.

With the company now trading near a four-year low, its risk-reward payoff is compelling.

Although prices for crude oil could continue to trend lower, the rebound could well be led by both Crescent Point and Suncor.

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846