Why Canadian energy stocks are a no-brainer

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Canadian oil and gas stocks were a compelling buy even before the sector’s latest drubbing. Now they’re almost a no-brainer.

Over the past few weeks, the energy sector has taken a big hit, as concerns about a global recession have knocked crude oil prices off their steady upward trajectory dating back to the start of the year.

The country’s big energy players, such as Canadian Natural Resources Ltd. and Imperial Oil Ltd., have seen their share prices drop by more than 15 per cent, while mid-sized oil producers, such as Crescent Point Energy Corp. and Whitecap Resources Inc., are nursing losses of closer to 30 per cent.

Global oil benchmarks, however, are still comfortably higher than US$100 a barrel, where they are very likely to remain for the foreseeable future.

That commodity backdrop equates to enormous profits for Canadian energy producers, which are suddenly on sale for those who still care to invest in fossil fuels.

“Investors absolutely should be taking advantage of the weakness here and buy,” said Randy Ollenberger, managing director of oil and gas equity research at BMO Nesbitt Burns. “What’s holding a lot of them back, I think, is just all the volatility in commodity prices.”

After soaring to record highs earlier this year, resource prices of all kinds have begun to reflect a shaky economic outlook. The combination of inflation, rising interest rates and growing signs of a downturn have driven down the prices of everything from copper to wheat to natural gas.

But the forces keeping energy prices high are enduring, whether there is a recession or not.

“Although the severity of a recession could put a dent in oil demand, history suggests it will not be big, if at all,” energy analyst Jason Bouvier at Scotia Capital wrote in a note.

Rarely does global demand for oil actually decline from one year to the next. It has only happened about a half-dozen times in the past 50-plus years – two of which were during the 1970s energy crisis, and two during the global financial crisis of 2007-08, Mr. Bouvier said.

When demand does slump on a worldwide basis, it tends to be on the order of 2 per cent. That pales in comparison with all the supply constraints still hanging over the global energy complex.

Nowhere in the world is there a major source of spare capacity ready to be tapped. This time around, the Organization of the Petroleum Exporting Countries is running out of room to boost production. And Russia is still producing around nine million barrels of oil a day, which could be increasingly squeezed by sanctions.

“We’re still looking at a supply shock – the largest we’ve seen since the 1970s, and it’s going to take several years for that to unwind,” Mr. Ollenberger said.

If triple-digit oil prices are an indefinite reality, Canadian oil stocks have a lot of catching up to do.

From the start of the year up to its peak in early June, the S&P/TSX Capped Energy Index gained 74 per cent, single-handedly keeping the Canadian stock market from falling into bear market territory.

Despite the impressive gains, the market never gave Canadian oil and gas stocks the benefit of US$100 oil – not even close. At the sector’s peak, it was priced for around US$70 a barrel. The recent sell-off took that number closer to US$60, Mr. Ollenberger estimates.

That should represent a huge margin of safety against current oil prices. But when West Texas Intermediate declined by about 15 per cent earlier this month, the Canadian energy sector fell by even more – 25 per cent, from peak to trough.

Much of that selling pressure was likely the result of profit-taking. After being the top performer on the TSX both year to date, and last year, the energy sector was a prime target for investors to lock in some gains.

After their sell-off, Canadian oil and gas names are not only cheap relative to energy prices, they are also cheap compared with their U.S. peers.

The discount is so large across the sector that investors can get plenty of upside potential by sticking with the largest names, such as Canadian Natural Resources Ltd., Suncor Energy Inc. and Cenovus Energy Inc., Mr. Ollenberger said. “You don’t have to go to some of the more volatile plays.”

Meanwhile, Scotia Capital’s Mr. Bouvier said he also prefers the integrated companies over the short term, citing Cenovus and Imperial Oil as top picks.

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