Stock Investing

The sector has struggled so far this year, but these picks have strong upside potential.
By Vikram Barhat | 27/09/17

The recent uptick in crude oil prices, the International Energy Agency forecast for growth in demand, along with falling output and the resultant reduction in supply glut have been fuelling a growing sense of optimism within the energy sector.

About the Author
Vikram Barhat is a Toronto-based financial writer specializing in investing, personal finance and small business. His experience working in various editorial capacities in digital and print media spans more than a decade across three continents. He has written for CNBC, BBC, The Globe and Mail, the Toronto Star and other publications. He can be reached on Twitter @vikrambarhath.

In Canada, particularly, the rising oil prices and demand trend have a positive impact on the overall strength of the domestic economy, to which the energy sector is a significant contributor.

However, unlike the U.S., the signs of this energy turnaround are yet to become visible in the Canadian energy stocks. While the S&P 500 Energy (Sector) Index has gained nearly 3.5% year-to-date, its Canadian counterpart, the S&P/TSX Capped Energy Index, is down 15.8%, for the same period, as of Sept 21, making it one of the worst-performing sectors in Canada so far this year.

On a year-to-date basis, leading Canadian energy names are still in the red, which creates attractive entry points for investors looking to increase their energy exposure.

The following energy producers have well-run, diversified businesses and stable cash flow, factors that provide a buffer in turbulent times and promise strong upside potential when the energy market swings back to profit on higher oil prices, among other factors, according to Morningstar equity research.

Cenovus Energy Inc.
Ticker:CVE
Current yield:1.56%
Forward P/E:74.8
Price:$12.70
Fair value:$21
Data as of Sept 25, 2017

An integrated oil company,  Cenovus Energy (CVE) develops oil sands and produces conventional crude oil, natural gas liquids and natural gas in Alberta and Saskatchewan in Canada, and has refining operations in the U.S.

Oil sands projects have high capital requirements and production costs, but Cenovus has found a solution with its solvent-aided process, or SAP, which holds the potential for the lowest-cost oil sands production in the industry. "We expect the implementation of this technology, albeit not for another few years, to provide Cenovus with the cost savings needed to be competitive with other marginal supply sources and generate free cash flow in a US$55/bbl environment," says a Morningstar report.

Cenovus maintains a strong balance sheet and its solvent-aided process could drive meaningful value in the long term, says Morningstar equity analyst Joe Gemino, noting that the market is vastly underestimating the potential of solvent-aided production.

The company's Narrows Lake greenfield expansion project, he adds, will achieve project break-evens at about US$45/bbl WTI. "As a result, Cenovus should be able to generate positive cash flow in midcycle environment," says Gemino.

The company's recent acquisition of the remaining stake in the Foster Creek Christina Lake Partnership presents newer cost-cutting opportunities, the report notes. On the other hand, Cenovus has been putting assets up for sale to help pay down debt from the US$13.3 billion deal with ConocoPhillips earlier this year to acquire full ownership of its oil-sands operations and a production platform in Western Canada.

Gemino assesses the stock's worth to be $21, which makes it "vastly undervalued" at the current price, incorporating enterprise value/EBITDA multiples of 9.5 times and 8.5 times for 2017 and 2018 respectively.

Enbridge Inc.
Ticker:ENB
Current yield:4.57%
Forward P/E:20.2
Price:$50.76
Fair value:$64
Data as of Sept 25, 2017

Canadian energy behemoth  Enbridge (ENB) owns and operates a network of assets that generate, store and transport oil and natural gas in North America. The firm also owns a regulated natural gas utility and Canada's largest natural gas distribution company. Enbridge also produces renewable and alternative energy.

The company is well positioned to benefit from growing oil sands supply dynamics with its Mainline system that "generates attractive tolls and represents approximately 70% of Canada's pipeline takeaway capacity," says a Morningstar equity report.

Enbridge's gas distribution operations benefit from regulated returns and provide the company with reliable cash flows. "Regulated ROEs on the gas utility and gas distribution assets consistently exceed 10%, providing another attractive asset to the portfolio that exceeds the company's cost of capital," notes the report.

Extensive regulatory oversight of assets, which acts as a barrier for new entrants, together with regulated tolls form sustainable competitive advantage for the wide-moat company. "Regulators in Canada and the U.S. permit Enbridge to recover costs to operate pipeline networks by collecting tolls for services," says Gemino.

The company has been rewarding investors with continued annual dividend growth. "Management maintains a strong average distributable cash coverage ratio of approximately 3.4 times, which will continue to allow the company to support its proposed dividend growth," says Gemino, who puts the stock's fair value at $64. "Enbridge's broad network of midstream assets and geographic diversification will serve it well in the low oil and gas price environment, and pipeline expansions in growing regions will fuel EBITDA growth."

Enbridge recently finalized its $37 billion acquisition of Spectra Energy in a deal that positions Enbridge to diversify its operations toward natural gas, with over $8 billion in secured expansion projects.

TransCanada Corp.
Ticker:TRP
Current yield:3.84%
Forward P/E:19.3
Price:$61.89
Fair value:$72
Data as of Sept 25, 2017

An energy infrastructure company,  TransCanada (TRP) operates pipeline and power generation assets in Canada, the U.S., and Mexico. The firm's pipeline network comprises more than 67,000 km of natural gas pipeline, along with the Keystone Pipeline system.

Growth projects in Mexico -- part of a $71-billion capital program that includes $23 billion in near-term projects -- position TransCanada to benefit from growing Mexican natural gas demand, while diversifying the company's natural gas operations away from Western Canada, where gas production has been in decline.

"TransCanada is developing five natural gas pipeline projects in Mexico, where natural gas pipeline shipments are expected to double by 2020," says a Morningstar report, noting these projects could generate approximately $540 million in annual EBITDA.

Moreover, the US$13 billion acquisition of Columbia Pipeline Group adds nearly 24,000 km of interstate natural gas pipelines that extend from New York to the Gulf of Mexico, positioning TransCanada in the fast-growing Marcellus and Utica regions.

"In addition, Columbia's $7 billion in future projects provides TransCanada with additional opportunities for growth beyond its current capital program," says Gemino who pegs the stock's fair value at $72, incorporating enterprise value/EBITDA multiples of 14 times for both this year and next. "Overall, TransCanada is in a strong position to benefit from the growing supply and demand of natural gas and boasts a strong growth asset in the Keystone XL."

TransCanada's broad network of pipelines and geographic diversification serve it well in the low-price oil environment, while pipeline expansions in growing regions promise to fuel EBITDA and cash distribution growth.

"The company," says Gemino, "intends to increase its dividend by 8% to 10% annually over the next five years and maintains a three-year distributable cash coverage ratio of approximately 3.5 times."

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