Two undervalued picks among Canadian energy producers

The market is overlooking some significant strengths in these two companies, which both trade at discounts to fair value estimates, says Morningstar equity analyst Joe Gemino.

Joe Gemino 12 September, 2017 | 5:00PM Christian Charest
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Christian Charest: For Morningstar, I'm Christian Charest. I'm talking with Joe Gemino, he is an equity analyst here with Morningstar who covers a number of Canadian energy producers. In a previous video, we talked about his outlook for the price of oil and for the Canadian energy sector in general. And here, we are going to talk about two of his favourite picks within that sector.

Now, Joe, let's start with Cenovus Energy. It currently has a 5-Star rating, which means it's significantly underpriced relative to your estimate of its fair value?

Joe Gemino: Right. So, best idea and 5-Star rated, Cenovus Energy, is our top pick among Canadian integrated stocks. It's trading at about a 50% discount to its fair value estimate. We believe that the market is narrowly focused on the company's temporary increase in leverage and is overlooking the company's immense growth potential in its oil sands reserves that can be brought online with its low-cost SAP technology, which is a form of solvent-assisted technology. We expect Cenovus to be the leader in solvent-assisted technology. Using SAP, we expect the company to possess best-in-class project economics with breakevens that approximate US$45 a barrel.

Now, the recent acquisition of the remaining interest in the Foster Creek Christina Lake partnership affords the company with over 7.5 million barrels of oil sands reserves.

Charest: Now, this improved solvent-assisted technology is something we discussed in our previous video, and you believe Cenovus is well-positioned to benefit from it?

Gemino: Yes, I do. Beginning next year Cenovus intends to begin converting some of its existing production to solvent-assisted technology which will lower its corporate cost structure. And over the next decade we see over half of the company's bitumen production coming from solvent-assisted technology. But the majority of the cash flow benefits from its solvent-assisted technology -- or SAP -- are several years away, which we think is causing the market to undervalue Cenovus today. Consequently, we believe the stock presents an attractive investment opportunity for long-term investors.

Charest: Your second pick is Enbridge which has a 4-Star rating?

Gemino: Correct. So, Enbridge is our top midstream pick and we see 20% upside in both Enbridge, Inc. and its master limited partnership -- or MLP -- Enbridge Energy Partners. Right now, we think the market is overlooking the impact of the Line 3 replacement project, which is a pipeline expansion project on the famous Canadian mainline. We think this project will strengthen the company's cash flows, bolster its returns on capital, strengthen its economic moat position and support its aggressive dividend growth strategy. We believe right now the market doesn't realize the full potential of Enbridge's growth portfolio which was strengthened by its recent acquisition of Spectra Energy along with the Line 3 replacement project.

Enbridge is also positioned with its oil sands pipelines to capitalize on further projected oil sands growth. As such, we expect Enbridge to continue to generate significant cash flows while being able to grow its dividend 10% annually over the next five years.

Charest: Now, you believe that the underappreciation of the Line 3 pipeline project also affects Enbridge's U.S. affiliate, the one you mentioned, Enbridge Energy Partners, which is a separate stock and also has a 4-Star rating?

Gemino: Correct. So, the Lakehead System, which is the U.S. portion of the Canadian mainline, is housed within Enbridge Energy Partners, the MLP. And we think that the company will also feel the same impact of the Line 3 replacement project that Enbridge, Inc. will. And similar to Enbridge, Inc., we think that the market doesn't realize the potential of the Line 3 replacement program to generate stable cash flows and excess returns for Enbridge Energy Partners. And additionally, the recent divestiture of the underperforming gas business really strengthens Enbridge Energy Partners and aligns it as a pure-play liquids pipeline MLP.

Charest: Joe, thank you very much for sharing your thoughts with us today on these energy stocks.

Gemino: Sure. Thanks.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.

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Joe Gemino

Joe Gemino  Joe Gemino, CPA, is an equity analyst for Morningstar covering Canadian oil and Gas companies.

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