Buy Canadian Heavy Oil Producers As The WCS-WTI Discount Narrows

Summary

• Buy Canadian heavy oil producers on the back of investor complacency and narrowing differentials.
• We explain the long-term tailwinds for Canadian heavy oil producers despite negative headlines.
• There are multiple near-term catalysts over the next several months which will boost investor sentiment.

Welcome to the Buy Canadian Heavy Oil Edition of Oil Markets Daily!

Thesis

Canadian heavy oil producer equities have diverged greatly from the recent improvement in Western Canadian Select prices or WCS. The discount between WCS and WTI continues to narrow, allowing knowledgeable investors to take advantage of the complacency in Canada.

Investors allocating capital to heavy oil producers in Canada will also benefit from a long tailwind of lower heavy oil production from Mexico and Venezuela, two key suppliers for US. This will provide more tailwind for higher Canadian heavy oil demand in the years ahead, and once crude by rail capacity increases, the discount will narrow even more boosting sentiment and trading multiples.

Given the small uncertainty surrounding the WCS to WTI discount situation, we think now is the time to buy Canadian heavy oil producers.

These are the names investors should consider:

• Athabasca Oil Corp. (ATH.TO) (OTCPK:ATHOF)
• Baytex (BTE) (BTE.TO)
• Gear Energy (OTCQX:GENGF) (GXE.TO)
• Meg Energy (OTCPK:MEGEF) (MEG.TO)
• Cenovus Energy (NYSE:CVE) (CVE.TO)

Other potential alternatives include Suncor Energy (SU) and Canadian Natural Resources (CNQ).

WCS to WTI Discount Narrowing

Last week, we published an article on Gear Energy and how it's now too cheap to ignore. The 2.8x EV/DACF trading multiple is a 47% discount to peers, and this multiple will only move lower as the discount between WCS and WTI narrows.

Since the Keystone outage in November that pushed spreads from $13/bbl to $30/bbl in early February, the discount has now narrowed to sub $20/bbl.

You can see in the chart above how the next 3 months have narrowed significantly since last week. The narrowing also comes on the back of no additional crude by rail capacity increases, and it is likely due to Keystone returning closer to full capacity. Third-party estimates still show Keystone operating below 100% due to US regulators. Once Keystone returns to full capacity, the entire curve should shift sub $20/bbl, and the front months will narrow even further.

Our analysis continues to indicate that once crude by rail, which has been bogged down due to delays in grain shipments as well as lack of locomotive capacity, increases in capacity, the spreads will narrow to ~$17/bbl and possibly even lower if crude imports from Venezuela and Mexico decrease.

Tailwind - Pipes and Lower Heavy Oil Production From Venezuela and Mexico

On March 7, we wrote an article on Venezuela. The article illustrated a chart of US crude imports from Venezuela:

It's no surprise that Venezuela's oil production has been in decline due to economic turmoil, but now with the risk of President Trump imposing new oil sanctions on Venezuela, the drop in heavy oil imports will have to be offset by another supplier, and in this case - Canada.

Source: IEA OMR

In addition, Mexico, another major heavy oil producer, will see its production decline in 2018. There is also a tail risk in Mexico where if Andres Manuel Lopez Obrador wins the Presidential Election in 2018, Mexico could close off its oil exports and instead focus on higher margin refined product exports. This could also provide another blow for US refineries processing heavy oil.

Source: IEA OMR

So, on the macro front, the headwinds for Mexico and Venezuela are tailwinds for Canada's heavy oil producers. But what's the point if you can't get Canadian heavy oil to the US, right?

Over the last 10 years, US has imported more and more Canadian heavy oil. But not only has the US imported more oil from Canada, but the mix has been trending more and more to the heavy grade side:

Pipes and Crude by Rail

There are currently three key Canadian pipeline projects in the mix:

1. Line 3 Replacement
2. Trans Mountain Expansion
3. Keystone XL

Adjusting for all three and using a sensible timeline to when these projects will come online gives us this chart:

As you can see, the issue with Canada today is just how do producers get their supplies to the market while waiting for the pipelines to get built. The answer is crude by rail, which has an estimated capacity of 800k b/d. The difference between the takeaway capacity needed today is around ~300k b/d, which equates to 441 tanker rail cars.

In our analysis of Canadian National (CNI) and Canadian Pacific (CP), the crude by rail bottleneck should be largely alleviated by the second half of this year as both railroads have signaled a material increase in locomotive capacity.

So, the real question comes down to when will Line 3 replacement start, because that's the first increase in takeaway capacity that's expected to come online.

On March 15, 2018, Minnesota regulators approved the final environmental review of Enbridge's proposal for the Line 3 replacement. The Public Utilities Commission voted unanimously to declare the review, "adequate." The next hurdle in the process of building the replacement will come on April 23^rd, when an administrative law judge releases her report on whether the project is needed. The PUC will then consider the recommendation for a final decision in June whether to grant a certificate for the project and approve the route. From all indications at the moment, the Line 3 replacement should not be an issue given the strong regulatory backings for the project to be approved. The PUC has already unanimously declared that the review was adequate, and now we are essentially waiting for the final stamp on this.

Once Line 3 replacement becomes a certainty, investors will start pricing in the lower WCS-WTI differentials ahead leading to much better investor sentiment. The next hurdle will then be the Trans Mountain expansion project, which is also on the right track.

On February 15, the National Energy Board (NEB) has already approved the go-ahead to start construction of the Trans Mountain expansion. While there has been a lot of news coverage of British Colombia vs. Alberta, the Federal Court of Appeal has already dismissed British Colombia's plea for allowing Kinder Morgan (KMI) to bypass local bylaws during the construction of the pipeline expansion. Soon enough, British Colombia will have run out of options to delay the build of this expansion and fold their already lost hand.

Once Trans Mountain Expansion becomes a certainty (we think by the summer of 2018), this will provide another key leg to investor sentiment about WCS-WTI spreads going forward.

With Line 3 and Trans Mountain in the bag, Keystone XL will just be an icing on the cake as you can see from the chart above that the capacity increase won't be needed till 2026 at the earliest, so we believe these two approvals will be enough.

When the crowd goes left, you go right

Contrarian for the sake of being a contrarian is suicidal, but in our years of analyzing business fundamentals and stocks, the set-up in Canadian heavy oil producers couldn't be more attractive on a risk/reward basis. Investors are paid for the uncertainty, while the long-term tailwinds are undoubtedly bullish.

Simultaneously, investor sentiment and cash flow multiples are at all-time lows, allowing investors to scoop up companies at a bargain to intrinsic value. All the while, investors also obtain optionality to the upside from an increase in oil prices due to bullish fundamentals.

We think with the catalysts we laid out in this article, Canadian heavy oil producers are a buy.

(Note: CCX.TO is the Canadian heavy oil benchmark ETN. The chart shows a stark divergence between producers and Canadian heavy oil prices.)

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Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long GXE.TO, MEG.TO. 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.