Stock Talk: Examining the Canadian energy sector

Melissa Kahnert: Hi, everyone and welcome back to this month’s edition of Stock Talk. Within the Canadian marketplace, there are many different industries that carry significant weight and give a lot of investment opportunities.

Today, we’re going to be examining the Canadian energy sector. And with us today is one of our Morningstar analysts, David McColl, who is going to be discussing many of the companies and big players within this industry, and how they are positioning themselves for the months ahead.

David, thank you very much for joining us today.

David McColl: Great, thanks for having me Melissa.

Kahnert: David, as the first quarter results have started to come through, what has been the general theme for the energy sector?

McColl: One of the themes that we’ve really seen this quarter has been extremely weak heavy oil price realizations and that means producers that basically are pumping heavy oil especially in Western Canada, have really been suffering. While on the other hand, integrated producers, so these are producers such as Suncor Energy and Imperial Oil that have refining assets, have actually been doing extremely well. In many cases, we’ve seen some record or near-record cash flow coming.

So, it’s a bit of a two sides to a coin here. On one side, heavy oil not so good; on the other side, integrated refining operations have done excellent.

Kahnert: That sounds interesting David. What would be the reason behind weak heavy oil prices and the strong refinery performance, specifically dealing with Suncor Energy, Cenovus, and MEG Energy?

McColl: Those are all three great companies to look at here because they all tell a bit of a different story. When we think about these weak heavy oil price realizations, we have to really look back a few years to understand where we’ve been and really where we’ve come. And what we’ve seen is just a surge of production within the United States, so this has been light oil production. While at the same time, we’ve seen really robust production of heavy oil coming out of Canada.

Now all of these factors really have conspired to kind of create this glut of crude in the U.S. Mid-Continent. In other words, there is all this crude coming into the Chicago area of the U.S., down to the Cushing area in Oklahoma, and it really can’t find a home. It’s stuck there.

So what that means is, heavy production, so heavy oil has had to sell at a significant discount to refineries. So, in that context, those who produce heavy oil are really suffering. They’re taking that discount on the chin, and then we think okay, well, how does that translate into – the integrated producers, why have they been doing so well?

Well, the easiest way to look at that is to look at a refinery and think about gasoline, just a good example; gasoline is basically priced off international imports. In other words, this is crude from the Middle East, from Angola, from Nigeria, that comes to coastal markets, to Tidewater. As we move all the way through the continent what we find is gassing others is priced off of these international products.

So what that means is if I’m a heavy oil refinery in the Mid-continent, I can purchase really cheap heavy crude and then sell it at an international price. So, in other words, they capture that whole spread. So, the integrated producers have really been winning off of that.

Kahnert: So, with the weak heavy oil price realizations, what is needed for these producers to recover?

McColl: Yeah, that's really an excellent question. So, when we think about MEG Energy, MEG Energy really suffered last quarter. They had their worst price realizations on record. And by way of background, MEG is one of Alberta's independent in situ oil sands producers. And in order for them to see a recovery, there's kind of a combination of factors. Either we need to see additional pipelines go down into particularly the U.S. Gulf Coast or we need to see movement by rail all the way down into the Gulf Coast or even by a barge.

And the reason why I'm saying the Gulf Coast is [that] the Gulf Coast is really the largest refining market in the world. They have very complex refineries, which mean they can handle a lot of heavy crude, and it's actually priced off international heavy, which is Maya crude. And that means that if a producer, a heavy oil producer, can get all their products down to the Gulf Coast instead of selling at a 25% to 35% discount, they should actually be selling, maybe, at a discount equivalent to transportation costs. So, that's a huge uplift from where they are today.

But the story is – we have to see pipelines come online from Enbridge. They're expanding their system down to the Gulf Coast. We have the Keystone XL Pipeline, which is TransCanada's large project, which has a lot of publicity right now, all the way down to the Gulf Coast. We really need to see those come online.

And the last thing I would point out is, Enbridge is reversing a pipeline and expanding it all the way into the Montreal area. While this pipeline we don't believe is actually going to be moving significant amounts of heavy crude or oil sands crude, it's important because it'll actually pull a lot of that light crude out of the Mid-continent and free up pipeline capacity. So, there's a lot of factors coming together that's going to take a few years to work itself out.

Kahnert: Who do you think is best positioned to take advantage of these new pipelines down in the Gulf Coast?

McColl: This is where we get to a bit of a kind of near-term longer-term story. In the near-term, we really like our integrated producers still. So, this is someone like Suncor Energy and even Cenovus to a degree. We like them because as we are still going to see these weak heavy oil prices over the next few years, they’re going to capture that differential. But as we see new pipelines come online and new transportation methods down to the Gulf Coast, they’re going to get a little bit of uplift because they’ll be producing more heavy crude than they have in the past. So, they’ll start getting some of these higher price realizations. Even though their downstream will be probably earning a little bit less than it has in the past, it will still be very robust.

But when we think really long term, investors who have an appetite for some significant risk tolerance, may want to look at one of our four-star stocks, MEG Energy. We like MEG because it’s a 100% exposed to heavy oil pricing. We also like them because they’re engaging a new program to bring crude to the Gulf Coast by rail, by barge, and by pipeline. So, we actually see their price realizations increasing by upwards of 30% by 2016-2017 – effectively through this new transportation strategy.

Kahnert: Thank you so much for your time today, David. That’s fantastic, lots of great information there.

McColl: Great. Thanks for having me, Melissa.

Kahnert: No problem. And to our audience, if you’re interested in any more information on the companies we discussed or if you’d like to check out more about what our analysts are saying, definitely visit us at morningstar.ca.