On a roll

The past couple of years have been something of a perfect storm for Canadian energy suppliers. Companies in the sector had cut back debt levels dramatically coming into to the rate hiking cycle. Indeed, looking at the TSX Energy Index, which captures oil production and exploration firms listed on the Toronto Stock Exchange, debt levels have come down dramatically since 2019 to close to zero today.

As they were doing this, oil prices started to rise and, although they have come down since the middle of the year, have remained at their most elevated levels in a decade.

This is part of the reason the managers of Middlefield Canadian Income (MCT) are bullish about the Canadian energy stocks today – something that is only compounded by the attractive valuation levels at which companies in the sector trade. On an EV/EBITDA basis, the TSX Energy Index is trading at levels last seen during the financial crisis in 2008. Is this warranted?

Commodities prices are notoriously hard to predict but there are arguably several tailwinds that could support Canadian energy stocks in the near future.

The first pertains to the mix of higher energy prices and those stronger balance sheets we’ve touched on already. With the latter coming into play and little to no debt costs, companies in the sector look capable of delivering much higher levels of free cash flow and offer the potential for double-digit dividend yields in the near term.

Prospective yields are so high in large part because of the comparatively low levels at which these companies trade, meaning there is also the potential for capital gains as well.

The catalyst for this may be the end of the rate hiking cycle. Canada’s central bank was quick to hike rates and contain inflation and it’s plausible we are now at the end of the cycle, with bond yields suggesting investors believe cuts are on the horizon. Assuming that is the case, the high prospective yields that energy stocks offer may start to look more attractive than they do already and push up share prices.

For the sector itself, earnings look set to be improved by growing demand from Asia, particularly for liquified natural gas (LNG). To give some sense of how disproportionately skewed demand growth is, energy research firm Wood Mackenzie estimates that Asian consumption of LNG will grow, on a cumulative basis, by 304 metric tonnes per annum (mtpa) in the period up until 2050. The region with the next largest growth in demand is Europe, which will increase by 29 mtpa. Wood Mackenzie also estimate that Canada can capture up to 31% of the Asian market in the next 25 years.

In part that’s due to logistical reasons. Most notably, Canada’s first export facility – LNG Canada – is expected to come online in the next couple of years. Currently Canadian natural gas is shipped to the US where it is exported as LNG to Asia via the Gulf Coast. Not only does this increase costs, it takes around three weeks to reach Asian markets. In contrast, buying from close to source in Canada is cheaper and shipping only takes seven to nine days.

LNG Canada is also a joint venture between Shell, which is the largest shareholder, and four other companies from Japan, South Korea, China, and Malaysia. That arguably points to another factor working in the Canadian energy sector’s favour. Although it is not an entirely neutral party, it is not at the forefront of tensions between the US and China.

Moreover, the country is a respected democracy with the rule of law, something that is not a common feature of many large-scale hydrocarbon exporters. This is why there have also been some early signs of demand from European countries for Canadian energy exports, although the infrastructure needed to export is currently lacking.

Finally, the main oil producers in the Gulf countries, notably Saudi Arabia, have little incentive to up supply today and bring prices down. Gulf countries have historically redirected oil revenues into foreign assets. Today they are attempting to pivot away from hydrocarbons and are thus investing huge sums of money in infrastructure projects and other industries, partly to build native industries and partly to lure foreign talent that will help them achieve that. That Saudi Arabia has consistently sought to keep the oil price above $80 a barrel in the past few years is one sign that this process will take some time and continues to require higher energy prices.

That is obviously not a guarantee, nor should it be taken as such, that Canada’s energy producers will continue to perform well. But for investors that believe there is a positive outlook for energy in the near term, MCT may prove to be an appealing way to play that trend.

The trust trades at a near 15% discount as at 30/11/2023 – over 30% wider than its 10yr historical average. That may start to tighten if investors see that we are at the end of the rate hiking cycle and the high prospective yields that energy stocks offer start to feed through into MCT itself.

Press continue below to access the full article...