Why oil's undervalued

The pipelines will be built, and they'll be tapped into new low-cost technology, says sector analyst Joe Gemino

Ruth Saldanha 28 October, 2019 | 1:57AM

 

 

Ruth Saldanha: Last month oil markets were shocked with an attack on a Saudi oil production facility. And for a while the oil markets and by extension, oil stocks were volatile. Now that the immediate shock has worn off, what is likely to happen. We released a report that said we believe that the energy sector is undervalued. Morningstar equity analyst Joe Gemino is here with us to talk about what he expects from Canadian energy and stocks.

Joe, thank you so much for being here today.

Joe Gemino: Thank you very much for having me, Ruth.

Saldanha: What's your overall view on the energy sector. And what are some of the risks that you are keeping your eye on?

Gemino: Right, so as of September energy looked to be the cheapest sector in Morningstar's coverage universe. We see opportunity in the oil field service stocks, which remain at valuation levels that we have not seen in quite some time. And Ruth the major risk revolves around OPEC, and how OPEC treats its future production cuts and whether they decide to bring more supply back into the market and try to recapture some of their lost market share.

Saldanha: Let's talk about Canada in particular, do you think Canadian energy stocks are undervalued right now?

Gemino: Right. Canadian energy stocks do look very cheap right now. We see opportunity in the oil sands producers, which is kind of driven by uncertainty over the future netbacks of their of their production and the industry – and the market kind of questions whether pipeline expansions will be built and the oil sands producers will be able to get market access for their productions. But we ultimately think that all three of the major pipeline expansion projects will be built, and the oil sands producers have developed enough low cost extraction technology, which will allow them to grow supply and fill all of the pipelines.

Saldanha: What are some of the risks you see for Canada?

Gemino: Well, the major risk really revolves around the pipeline expansion projects. If the pipeline expansions are not built, you would see the oil sands producers suffering lower netbacks on their production and lower cash flows. And really, they wouldn't be able to grow their supply and showcase some of this lower cost extraction technology.

Saldanha: Finally, Joe, what's your top Canadian energy pick for now?

Gemino: Well, Ruth, there are two names that stand out and both of them are Morningstar Best Ideas. The first is wide moat Enbridge (ENB). We see 35% upside in the Four-star stock coupled with a 6.3% dividend yield. And right now, the market has concerns over the Line 3 Replacement Project. And even though the project has suffered some delays, we still expect the pipeline to be built. The market has also expressed concerns over the future of Enbridge's Line 5 pipeline, which has been subject to some legal challenges. However, we do expect the pipeline to remain in service in its full capacity. And finally, we expect Enbridge to generate significant free cash flow and grow its dividend at 10% next year with annual increases of 3% thereafter.

And the second stock that we like is Cenovus Energy (CVE). The stock is trading at a 45% discount to our fair value. The market has some concerns over the company's netbacks with its lack of market access. But we think once the pipelines are built, that Cenovus will be able to realize its immense growth potential in its oil sands reserves that it can bring on line with its industry leading, low cost, solvent aided technology.

Saldanha: So, Enbridge and Cenovus we'll keep our eye on those. Thanks so much for joining us today, Joe.

Gemino: Thanks again for having me Ruth. Have a great one.

Saldanha: For Morningstar, I'm Ruth Saldana.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Cenovus Energy Inc11.86 CAD0.42
Enbridge Inc50.22 CAD0.56

About Author

Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca