Welcome to the production curtailment edition of Oil Markets Daily!
Variant perceptions are often hard to come by, but when there are no competitors competing against you for a variant perception, it’s much easier to find one.
In the case of Canadian energy stocks, the hatred towards this sector has risen to new heights. As a percentage of the Canadian stock market, Canadian energy stock weighting has fallen to a new record low.
This happened despite the fact that energy contributes just under 10% of Canada’s GDP.
The hatred has, however, fueled the victory for the Conservative party in Alberta with Jason Kenney as its new leader. Since being elected, Kenney has gone on a campaign of supporting Alberta’s struggling energy sector. The most pivotal moment was, however, on Friday, when he announced a “war room” armed with C$30 million in the budget to combat sentiment and fake news on the environment and Canada’s energy sector. In addition, Kenney reiterated the need to be “cautious” with Alberta’s pipeline takeaway capacity issue. We quote as follows:
NDP-introduced legislation that capped oil production in this province is set to expire at the end of the year, and Kenney said his government had hoped to allow that deadline to pass without extending it.
However, the premier said delays to the replacement of Enbridge's (ENB) Line 3 along with high inventory levels could mean that doesn't happen.
"Our government will have to proceed cautiously," said Kenney, who added that his government "cannot allow" a severe oil price differential to occur.
What happens if Alberta does extend the production curtailment into 2020? What would that do to WCS-WTI differentials?
For starters, keep in mind that year-to-date WCS-WTI differentials have only averaged $11.18/bbl. This is likely too low, as we think a conservative estimate around $15/bbl will suffice in getting crude-by-rail to ramp up.
Second, the market is still pricing none of this in via the WCS-WTI curve:
(Source: ICE, HFI Research Estimate)
As you can see, the curve is currently trading massively below our estimate, likely explaining why Canadian energy stocks remain depressed.
Lastly, if we combine the WTI futures curve with our expectations, our variant perception is in that the market is likely underappreciating Canadian energy names by more than 100%!
(Source: ICE, HFI Research Estimate)
Our WTI forecast along with the WCS-WTI differential forecast shows a price difference of 100%! The market only sees a realized price of $30/bbl, while we see pricing closer to $60/bbl.
How will the market close this forecast gap?
There are a few key events that will happen in the next few months that will close this gap.
First, WTI needs to rise to $70/bbl, as our forecast for US crude draws and global inventory draws need to come to fruition.
Second, as the trading community realizes that Alberta will extend the production curtailment into the end of 2020, the spreads will start to compress, from the ~$21+/bbl to $18 or lower. We’ve seen this with the prompt spreads tightening from $18/bbl to under $14/bbl.
Third, the Trans Mountain expansion announcement is expected on June 18th, which could provide more clarity on takeaway capacity. All early indications point to this being a go-ahead of this important date, so sentiment will get a big boost along with traders’ expectation of spreads. Also keep in mind that TMX would give Canadian heavy oil exposure access to global pricing, where heavy differentials to light are already sinking to multi-year lows. This would give Canadian producers pricing close to that of Dubai, which is only $3/bbl below Brent.
Lastly, as the summer refining season continues, the shortage of heavy crude should become ever more apparent. This should increase the price premium in the Gulf for WCS Houston and result in a decrease in WCS-WTI spreads.
If the playbook is as we expect, we think the curve would be lifted over the summer, boosting sentiment in the market towards Canadian energy stocks.
Federal Election… Another Catalyst?
Canada’s federal election will be held on October 21st, 2019. The market has perceived a Trudeau-led government as bearish for Canadian energy, while a conservative victory led by Andrew Scheer would be viewed as very bullish. Currently, poll results show the conservatives with a lead of 3.6% over the Liberals. While the poll results are far too early to have any real predictable value, keep in mind that the Liberals were leading by this margin just earlier this year.
The SNC-Lavalin scandal massively damaged the Liberal’s image, so the odds are much more 50/50 now.
If the Conservatives win in October, the boost to sentiment would catapult Canadian energy stocks higher. More pipelines will be built given the focus on using more Canadian oil for refineries in the East. This, alongside with Keystone recently getting approval for construction in the US, should push investors to look at the sector in a more positive light.
While the price action for Canadian energy stocks has been terrible since the Conservatives won in Alberta, the recent price action suggests a rebound is coming.
XEG.TO, the Canadian energy sector ETF, is forming this falling wedge pattern, with the TSI ready to bottom out.
Cenovus (CVE) broke out on Friday above the falling wedge pattern, and the TSI is starting to turn higher.
Gear Energy (OTCPK:GENGF) also broke out of the falling wedge pattern, with the TSI ready to cross.
These charts lead us to believe that the rebound in Canadian energy stocks is coming. And following the comments from Premier Kenney on the need to be “cautious” and potentially extending the production curtailment into the end of 2020, we believe this variant perception will catapult Canadian energy stocks higher.
With Canadian energy stocks now trading at the lowest level relative to TSX in history, we believe there are a lot of catalysts on the horizon that can fix this. First, we believe Trans Mountain expansion will finally be approved, resulting in a visible takeaway capacity of +580k b/d. Second, we believe Alberta will extend the production curtailment into the end of 2020 or until either Enbridge's Line 3 or the Trans Mountain expansion comes on-line. Third, we think the Federal Election with a conservative victory may jolt sentiment. Finally, we believe our oil market analysis points to higher prices, and this, combined with the production curtailment, should push WCS nearly 100% higher than what the forward curve is saying.
We remain very bullish in Canadian energy stocks.
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Disclosure: I am/we are long CVE.TO, GXE.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.