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3 Dirt-Cheap Canadian Oil Producers
If you're looking for value, small-cap Canadian energy is a good place to start
I’ll be the first to admit oil exposure has helped dull some of the overall pain endured by the rest of my portfolio in 2022.
My philosophy towards buying oil stocks — which I did from 2018 - 2020, picking up a notable position each year — was relatively simple. The commodity was cheap and unloved. Everyone was talking about how electric motors would replace internal combustion engines and how we’d work from home forever.
I could choose from the trashy producers who had been trading firmly in penny stock situations for years, the kinds of companies that could easily go to zero or be ten-baggers. I chose the highest quality names in the sector instead, the kinds of companies with lots of production reserves and refining divisions to help generate some earnings as I waited for the commodity to come around. I also wanted to get paid while I wait because, dammit, I always want to get paid while I wait.
I settled on a portfolio with relatively equal positions in three of Canada’s largest oil sands producers — Imperial Oil (TSX:IMO), Suncor (TSX:SU)(NYSE:SU) and Canadian Natural Resources (TSX:CNQ)(NYSE:CNQ). They were, collectively, approximately 3% of my portfolio at time of purchase and even after moving up an average of 100%+ each, they’re still at less than 5% of my portfolio. They’ve done well, but most of the other stuff I owned went up too. I also added RRSP contributions, TFSA $$$, etc.
I’m content with these three names and I’m not looking to add anything in the energy sector today. This is despite being pretty damn bullish on oil. The fundamentals of this still unloved commodity look good for years to come as various governments around the world — including Canada’s — essentially look to diversify out of the energy business. Energy producers and their shareholders see the writing on the wall and are making sure long-suffering shareholders see some return on their capital, opting to spend cash flow on dividends and buybacks rather than materially increasing production.
Despite this newfound belief in taking care of shareholders, plenty of investors are staying away from energy producers. It was just two years ago the price of a barrel of crude dipped to negative prices. And it’s not hard to squint and imagine a world where electric cars zip around without burning fuel. It looks like we’ll get one last oil boom and the commodity will fade away forever.
Put it all together and we have a situation where oil is nearly $120 per barrel and a skeptical market believing the true equilibrium price should be somewhere around $70 or $80. If $120 per barrel — or higher — crude is the reality, there are some incredibly cheap oil producers out there. They’ll make back their current market caps in cash flow in just a handful of years without investing in new production.
Let’s take a closer look at three.
It seems like Cenovus Energy (TSX:CVE)(NYSE:CVE) is the forgotten sister of the major oil sands producers. Everyone focuses on the three I already mentioned above — Suncor, Imperial, and Canadian Natural — despite Cenovus being a behemoth in its own right. The company looks to produce 780,000 barrels of oil per day in 2022, with approximately 80% of production to come from the oil sands. It also has conventional production and a little offshore production it acquired from Husky.
Cenovus also has significant downstream assets, including refining and upgrading capacity of nearly 700,000 barrels of oil per day. Most of its refineries are located in the United States.
The company generated $2.6B in funds flow in its most recent quarter, a number I’ll simply multiply by four to get an annualized figure. Subtract out $3 billion in capex and Cenovus is expected to generate $7 billion in free cash flow.
As I type this, Cenovus has a market cap of $49 billion. 7x FCF is pretty damn cheap.
Cenovus also has a simple capital allocation plan. 100% of excess cash flow will go towards paying down debt until the net debt hits $9 billion. From $9 billion to $4 billion in debt the company will use 50% of excess funds flow to pay down debt and 50% to give back to shareholders, either in the form of special dividends or share repurchases.
The current debt, by the way, is a hair over $11B. Meaning Cenovus will be in the position sometime this summer to really start giving back to shareholders.
Cenovus also tripled its base dividend, which currently stands at $0.42 per share. This dividend is sustainable even at $45 per barrel WTI.
Back when I wrote for a certain investing website that shall remain nameless, there was an easy formula for generating a little buzz around an article on the energy sector. You just had to mention Baytex Energy (TSX:BTE)(NYSE:BTE) and say some variation of “if we hit ‘x’ oil price, Baytex stock should do ‘y’.
It was easy, mostly because Baytex shareholders were desperate for a sniff of the glory days again.
It’s now a handful of years later and all the long-suffering Baytex bagholders have moved on, likely turning themselves into now long-suffering tech bagholders or some other such nonsense. A whole new shareholder base has crowded into Baytex, looking to finally reap some of the benefit of the company’s promising array of assets.
I won’t get into details of the company’s production because, quite frankly, nobody cares. I’ll focus on the financial side of things, which looks to be quite promising. Baytex has a current market cap of $3.9 billion. It plans to generate $3 billion in free cash flow over the next five years. At that pace, investors will get their entire investment back in FCF in just six years.
There are caveats, of course. Baytex is ramping up to its $3 billion plan. Based on Q1 free cash flow of $120M it still has a little ways to go before hitting the $600M annual number it’ll need to hit the goal. But the company is paying down debt at a pretty good clip and it also plans to start a pretty significant share buyback this quarter. Any meaningful buyback will just increase returns to existing shareholders.
Perpetual Energy (TSX:PMT) is a fun little throwback for your author. It was one of the very first stocks I bought on my own as a 20-year-old investor back in 2003, back when it was called Paramount Energy Trust. Initially attracted to the massive dividend (oh how little things change), I got lucky on the direction of the overall energy market and sold at a profit in about 2004.
After years (many years) in the doghouse, Perpetual started living up to its name only recently. Shares have been on fire as production increases and an overall improvement in outlook for the energy sector have caused investors to take another look at this name.
First quarter production increased to nearly 7,000 barrels of oil equivalent, increasing some 25%. Of note here is Perpetual is primarily a natural gas producer. Approximately 75% of production is natural gas or equivalents. Both Cenovus and Baytex have a much higher focus on oil.
There are a couple of ways you can value Perpetual. The first one is the value of the reserves. Based on management’s valuation method, Perpetual’s upcoming drilling inventory is worth $3.80 per share. The current stock price is $1.27 per share.
Perpetual is also cheap on a price-to-cash flow basis. Funds flow should be approximately $60M in 2022, depending of course on the commodity price cooperating. Capital expenditures should be around $30 million. That leaves us $30 million worth of free cash flow, excess capital Perpetual will put towards debt. The current market cap is just $80M, putting this growing energy producer at less than 3x forward FCF.
Finally, Perpetual comes with an interesting wild card. It sold a bunch of assets to Rublelite, and in exchange received mostly promissory notes, shares, and warrants to buy additional shares. These assets are a significant part of Perpetual’s balance sheet and could provide some additional upside if oil maintains its current lofty price.
The bottom line
I’m just a tourist in the energy space, and I intentionally keep things simple when it comes to my own portfolio. I buy the best quality assets when they’re unloved. I’ll look to sell some when they’re extra frothy, but I don’t think we’re anywhere close to that yet.
I was lucky to buy a while ago when you could get those high quality assets on sale. That’s not really the case any longer, meaning you’ll have to dig a little deeper if you want cheap energy names.
Cenovus, Baytex, and Perpetual are a good place to start, but don’t exhaust your search there. There are dozens of different energy producers, each offering a compelling value proposition if the price of the commodity continues to cooperate.