Challenges And Opportunities In Canada's Oil And Gas Industry

by: Roger S. Conrad

At one point last winter, Western Canada Select (WCS) crude oil traded at a discount of $40.00 per barrel to West Texas Intermediate (NYSE:WTI), leaving some Canadian producers struggling to make ends meet while their US counterparts posted solid profits.

By summer 2013, this price differential had narrowed to less than $10.00 per barrel, thanks to the resumption of service on certain pipelines and record shipments of Canadian crude oil and bitumen by rail.

Source: Bloomberg

However, the WTI-WCS price spread has widened once again, hitting $39.00 per barrel and putting Canadian oil producers under pressure once again.

Welcome to the new reality for Canada's energy patch. Although Alberta's oil sands and unconventional plays such as the Cardium, Horn Lake and the Montney Shale promise to be prolific, the distance between these vast reserves and the major North American refineries is considerable and insufficient pipeline capacity remains a challenge.

And rising US oil production has congested the US pipeline network, sometimes crowding out volumes from Canada.

All this adds up to a boon for Canada's best-positioned midstream companies, which enjoy a steady pipeline of low-risk expansion opportunities. Investors in Altagas (ATGFF), Pembina Pipeline Corp (NYSE: PBA) and the other names we highlighted in Canada's Midstream Marvels can look forward to a rising stream of dividends and solid capital gains over the long term.

Canadian oil and gas producers, on the other hand, must contend with volatile price differentials. Some companies have done a much better job than others in hedging their exposure and/or finding alternative means to deliver their output to market. Others produce primarily light-sweet crude oil, which usually commands a better price than heavier varietals and is less expensive to deliver to end-markets.

Expect these wild swings in oil prices to weigh on some operators' ability to grow their reserves and production while maintaining their dividends.

Price differentials improved significantly in the third quarter - a welcome boon for upstream-only companies. However, integrated oil companies such as Suncor Energy (NYSE: SU) and Cenovus Energy (NYSE: CVE) tend to hold up reasonably well when price differentials widen because of their well-positioned refineries. (See Top Canadian Energy Stocks.)

With the price spread between WCS and WTI jumping to $39 per barrel in the fourth quarter, meeting production targets, executing hedging strategies and managing credit lines will be critical.

Oddly enough, natural gas could remain a bright spot for many Canadian producers, at least in comparison with 2012. But the price gap between Canadian gas at the AECO hub and both WCS and WTI crude oil will keep most producers shifting drilling activity toward liquids.

Separating the Wheat from the Chaff

Companies that produce primarily light-sweet crude oil, which requires less processing and is easier to ship, will feel the pressure of widening differentials - but not to the same extent as outfits that produce heavier crude oils.

Heavy crude oil historically has traded at a discount to light-sweet crude oil - transportation bottlenecks mean that temporary pipeline and refinery outages quickly exacerbate this price gap.

Operators in Canada's oil sands enjoy the unwavering support of Canada's federal government and Alberta's provincial leaders. And the big money backing these projects and prospective customers in Asia don't scare easily.

But the fierce opposition to the cross-border leg of TransCanada Corp's (NYSE: TRP) Keystone XL pipeline serves as a reminder that carbon emissions remain a hot button issue. Some large investors now demand that companies spell out the risks to cash flow and production growth from potential environmental protection laws.

Smaller companies generally pose more risk than larger producers - one of the main reasons that the pace of mergers and acquisitions activity in Canada's energy patch could accelerate.

A union of some of the larger players in this space might not be out of the question - the combined company would enjoy superior access to capital and likely would handle transportation bottlenecks better.

History shows that eventually the oil and gas will flow to the end-markets willing to pay the highest price. The necessary midstream infrastructure will be built, shrinking price differentials. But this point of stability remains several years off.

In this environment, investors need to be nimble and selective; Penn West Petroleum's (NYSE: PWE) 48.2 percent dividend cut won't be the sector's last. There's value in those hills, but avoiding dry holes will require some vigilance.

Here are my revised rules for income-seeking investors looking for above-average yields from Canada's oil and gas producers.

  • Stick to larger companies. Focus on average daily production, which drives cash flow the size of a firm's balance sheet.
  • Monitor all-in payout ratios, which combine capital spending and dividends. Companies that generate enough cash flow to pay their dividend and make the necessary investments in their business don't have to rely on credit lines or dilutive equity issues to fund production and reserve growth.
  • Investors should prefer companies that primarily produce liquid hydrocarbons, as these firms usually fetch higher prices for their output. One exception to this rule: Peyto Exploration & Development Corp (PEYUF), a natural-gas producer that enjoys industry-leading profit margins because of its low cost structure. Natural-gas producers are also immune to fluctuations in oil prices.
  • Focus on trends in companies' net debt-to-cash flow ratios. A steep rise in this ratio can be a sign of trouble. Also pay attention to companies' near-term refinancing needs and the remaining capacity on their credit lines.
  • Don't overpay for favorites. Given the volatility in energy prices, investors should have ample opportunity to pick up our high-quality names such as ARC Resources (AETUF), Peyto Exploration & Development and Vermilion Energy (NYSE: VET) at prices that are below our buy targets. Patience is critical.

Check out our table of Canadian Energy Stocks for vital statistics and our updated take on more than 30 upstream operators that pay dividends.

Best Buys

Pengrowth Energy Corp (NYSE: PGH) slashed its dividend about a year ago in response to falling energy prices and has divested $985 million worth of non-core assets to help fund its promising Lindbergh project in the oil sands.

Management's rationale behind this strategy: Replacing higher-cost production and assets that exhibit a steeper decline rate with longer-lived projects that have lower lifting costs. Although the start-up of Lindbergh will be capital-intensive, management expects the firm to fund the project's first phase without issuing additional debt or equity.

The risk-reward balance with Lindbergh appears favorable. Not only did management choose the right size oil-sands project instead of biting off more than the company can chew, but the low decline rates exhibited by test wells in the play are also ideal to support the firm's monthly dividend.

The project, which is slated to come onstream in early 2015, should increase liquid hydrocarbons to 80 percent of Pengrowth Energy's production mix by 2018 and has the potential to double the company's cash flow.

Meanwhile, the company continues to generate enough cash flow from its legacy operations to fund its monthly dividend of CA$0.04 per share. During the third quarter, Pengrowth Energy lifted 83,275 barrels of oil equivalent from its legacy operations and generated CA$0.31 per share in funds from operations.

Pengrowth Energy Corp rates a buy for aggressive investors who can stomach the volatility.

Crescent Point Energy Corp (CSCTF) is a solid pick for conservative investors, though you should wait for a pullback before establishing or adding to a position.

Crescent Point Energy's third-quarter production topped 117,500 barrels of oil equivalent per day - an increase of 18 percent from year-ago levels. Meanwhile, the company's average daily output in September exceeded management's prior target for the company's 2013 exit rate. In light of these strong results, the firm now expects to produce 124,000 barrels of oil equivalent per day at the end of the year.

More impressive, the company achieved this production growth while spending CA$250 million less than planned.

With improved oil price realizations, the company posted record funds from operations of CA$554 million, which translated into a payout ratio of about 49 percent. However, when you factor in acquisition costs and capital expenditures, Crescent Point Energy's all-in payout ratio came in at 143 percent during the third quarter.

The upstream operator has hedged its anticipated 2013 and 2014 production aggressively, which should help to insulate the firm from volatile price differentials.

By maintaining its monthly payout after converting from a royalty trust to a corporation, Crescent Point Energy's share price has held up reasonably well, enabling the company to finance acquisitions via opportunity equity issues. Nevertheless, the firm has continued to grow its production per share.

The upshot is that Crescent Point Energy has managed to grow its hydrocarbon output without weakening its balance sheet and thus far has dealt with fluctuating price differentials with aplomb.

Disclosure: I am long PGH, CVE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.