CVE:CC - MEG Energy: 3 Reasons To Consider Moving To Suncor

2023-04-24 08:00:00 ET

Summary

• MEG Energy got a rare buy rating from us in 2022.
• The stock has outperformed its benchmark index by 24% in the last 5 months.
• We think a shift makes sense.

Note: Amounts are in CAD and all prices referenced are on TSX unless stated otherwise.

On our last coverage of MEG Energy ( MEG:CA ), we gave it a "Buy" rating, noting that there was a higher element of risk here. Specifically we said,

As investors continue to see capital discipline and lowered volatility, we believe multiples are likely to expand to perhaps 6X EV to EBITDA within two years. While that may not get MEG back to its 2014 multiples, it would spell an upside of 60% from here over the next two years adjusting for debt reduction and buybacks. We rate the shares as a buy, while noting that its complete lack of hedges will likely make it more volatile than the average oil company.

Source: The Little Oilsands Company That Could

The thesis has played out so far at least with MEG delivering an outstanding return profile versus iShares S&P/TSX Capped Energy ETF ( XEG:CA ) and Energy Select Sector SPDR ETF ( XLE ). XLE's performance shown is in US Dollars and on NYSE.

We review the recent guidance from the company and tell you three reasons why we are shifting our position on this.

1) Royalty Bump Reduces Cash Flow In 2023 And Beyond

It is easy to look past cash flow bumps in bull markets and MEG's near perfect execution in 2022 certainly helped. But 2023 is likely to be materially different than 2022 for a few reasons. Christina Lake for one, will start costing the company a lot more as it moves to a post payout structure.

The pre-payout royalty is based on the project’s gross revenue multiplied by a gross revenue royalty rate. Gross revenues are comprised of bitumen realization after transportation and storage expense attributed to the project. The gross revenue royalty rate starts at 1% and increases every dollar the WTI oil price in Canadian dollars is priced above $55 per barrel, to a maximum of 9% when the Canadian WTI price is $120 per barrel or higher. The post-payout royalty is the greater of (i) the gross revenue royalty; or (ii) the net revenue royalty. Net revenues are comprised of bitumen realization after transportation and storage expense attributed to the project, and allowed operating and capital costs. The net revenue royalty rate is based on a formula which starts at 25% and increases for every dollar the Canadian dollar WTI oil price is above $55 per barrel to a maximum of 40% when the Canadian WTI price is $120 per barrel or higher. The Corporation’s Christina Lake operation is currently in pre-payout status, with payout anticipated to be reached in the first quarter of 2023.

Source: MEG 2022 Annual Report

The exact rate will depend on the exact price of bitumen but we estimate that royalties will be at least 2X 2022 levels and perhaps as high as 3X. So MEG will be facing a rather unique combination of falling crude oil prices relative to 2022 alongside a bigger take by the government.

2) Highest Sensitivity To Western Canadian Select ((WCS))

MEG's outperformance over the last few months has a lot to do with how WCS has traded.

WCS for May delivery in Hardisty, Alberta, traded between $15.60 USD and $15.50 USD a barrel under WTI, according to brokerage CalRock, having traded between $15.75 USD and $15.50 USD a barrel under the U.S. benchmark on Wednesday.

Despite the widening, Canadian heavy crude remains relatively strong. The WCS differential reached its narrowest level since last May in recent days at around $14 USD a barrel under WTI.

One market player said the market was holding steady, with support for Canadian heavy and synthetic crude expected as oil sands turnaround season ramps up. Maintenance at oil sands projects typically cuts supply and boosts prices.

Source: BOE Report

Due to a lack of downstream exposure, MEG is the most sensitive to these differentials compared to Suncor Energy Inc. ( SU ), ( SU:CA ), Imperial Oil Limited ( IMO ), ( IMO:CA ) and Cenovus Energy Inc. ( CVE ), ( CVE:CA ). Even a reversal of this trend alongside a lower crude oil price in 2023, could really impact MEG disproportionately. Based on our estimates of a modestly weaker strip price than what we have right now, MEG's cash flow per share could drop about 40% from 2022 to 2023. By comparison, Suncor's will drop less than 20% in a similar environment.

3) Valuation Compelling On An Absolute Basis, But Not So Much On A Relative Basis.

MEG has focused on debt reduction and share buybacks. After a drought of returns from this stock (remember that the other large caps pay decent dividends), this has really been appreciated. This has probably also contributed to the outperformance.

It has also led to an unusual situation where the free cash flow yield for MEG is lower than SU, IMO and CVE.

Note that here free cash flow yield is calculated as after capex, but before dividends, to level the playing field for dividend payer and non dividend payers. MEG's 10-12% free cash flow yield pales compared to 15% plus for the remaining three. Historically it has been the reverse as MEG is a smaller and riskier player. Even taking into account the debt and valuing on an EV to EBITDA (2024) basis shows that MEG is the most expensive.

MEG's relative valuation is getting harder to justify with recession risks. MEG's credit rating at B+ (Fitch) is also several notches lower than IMO at AA and SU at BBB+.

Verdict

Earlier we had shown the performance of MEG versus XEG:CA. Here is the same chart versus the three sidekicks of our story.

Based on valuations and relative performance, we prefer SU here versus MEG. We still think MEG makes you money from here long term but it is really hard to continue a buy rating on this with the choices we have. We are downgrading MEG stock to a Hold rating and maintaining a Buy on SU. We still hold some MEG and have sold the $20 Covered Calls for January 2024 against that position.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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