OILX - What Higher Oil Prices Could Mean For Canada's Energy Sector And Investors
2023-08-28 19:05:00 ET
Summary
- Have oil's supply and demand fundamentals finally started to line up?
- Why Canadian pipeline stocks may still face challenges as oil prices rise.
- The outlook for higher-yielding dividend stocks as interest rates remain high.
Oil prices have strengthened in recent months, suggesting to some the commodity’s fundamental underpinnings may be stabilizing. Michael O’Brien, Portfolio Manager at TD Asset Management, looks at the implications for Canadian energy stocks and potential opportunities for investors.
Greg Bonnell: As you can see, in the last few months, we've seen crude starting to show some signs of stabilizing after some sizable gains through the summer. Well, that could translate into potential opportunities for Canadian energy stocks, but they're a diverse group. Here to help us take a closer look at the energy space here in Canada is Michael O'Brien, Portfolio Manager at TD Asset Management. Michael, always great to have you on the program.
Michael O'Brien: Yeah. Thanks for having me back.
Greg Bonnell: So we've seen this move higher in the price of crude after what's been a challenging year for energy investors. Could we expect to see more strength, some consistency, going forward?
Michael O'Brien: Well, I think the supply-demand fundamentals are finally starting to line up the way we had hoped at the beginning of the year, but you're right, it was a tough slog, the first six or seven months. What we had expected coming into the year was the supply, not so much the demand. We weren't as concerned about that, but we felt that there was going to be some significant tightness in supply. Kept waiting to see those inventory drawdowns. They're finally starting to materialize now, and I think that's really what's put a more fundamental base underneath the oil price.
Now, the reality is oil is, the price of oil moves around a lot more than the supply-demand fundamentals do, and so, macro headlines are going to knock it up and down. But I think the fundamental underpinning here looks better than it has in quite some time.
Greg Bonnell: Before we get on to the stocks, I quickly want to ask you what's happening in China, the world's second-largest economy. They consume a lot of commodities. It hasn't been great there. How much do we need to keep that in mind if we're energy investors?
Michael O'Brien: Well, China, obviously, is the 800 pounds gorilla in the commodities market. What's interesting, though, is relative to things like copper, they're very much geared to their industrial production, the manufacturing side of the economy.
I think the story for oil in China has been more about the Chinese ending the lockdowns, letting people move around. And at the end of the day, oil is about -- it's a transportation fuel. It's about moving people and things around. So the demand, so far this year, out of China has actually been quite solid, contrary to what you might have expected.
Greg Bonnell: OK. Contrary indeed to what I did expect, so I'm glad I got that in there. Let's talk about the energy-related stocks. So we've seen this move higher in the price of crude, and it's been a fairly substantial one over the past couple of months, not really being priced into the energy stocks right now. What's going on there?
Michael O'Brien: Well, it's starting to come. I mean, they've had a better -- this third quarter so far has been a little more encouraging, and energy stocks are starting to participate in what has been a pretty good year for markets. In our view, there's still more to come here. And I think what's really intriguing about this space is, there still aren't really high expectations on the part of investors. But if you give a lot of these Canadian producers $80, plus or minus, they're going to generate a lot of free cash flow.
And one of the things we've been focused on for some time, which I think is something we don't want to take our eye off the ball, a lot of these Canadian producers, they spent the last couple of years doing what they should have done, which was repair their balance sheets, get the balance sheets in order, get their debt levels down. But we're really getting to an interesting point where a lot of the major producers are very close to hitting those debt level targets.
You take Canadian Natural Resources ( CNQ ), Cenovus (CVE), some of the big hitters. Some were -- late this year, early next year, they're going to reach those debt targets, which means all that free cash flow is coming back to us as investors. So I think that's the opportunity, is what could be a difficult time for markets overall. You're going to be seeing a subgroup of companies here that are going to be sending a lot of cash back to shareholders.
Greg Bonnell: All right. So that's some of the big names, you mentioned some of them there. But the pipeline stocks, they don't seem to be sort of catching a bid like some of these energy names are during this rally in crude. What's going on there?
Michael O'Brien: Yeah. So that's partly self-inflicted and partly another, I would say, broader issue that's affecting a lot of other stocks too. So to get the macro out of the way, one of the things that's weighed on the pipeline stocks, like TC Energy (TRP), like Enbridge (ENB), is the same thing that's weighed on a lot of the traditional dividend-paying, high-yielding stocks in the TSX Composite, your BCEs, your Telus (TU), Fortis (FTS), Amira, these types of names.
And what that is, is simply they have to compete for investor dollars with cash, with GICs. And for the last 10, 15 years, there wasn't much competition at all. But as we've seen interest rates begin to rise and investors have other options, those dividend yields have to rise, too, to keep that attraction. So that's the more general comment.
Greg Bonnell: I think we can actually show a picture of that that we can speak to in terms of what we've seen in rates in the bond market and from central banks and what it actually means. I mean, there's the Canadian 10-year right there represented by the white line, and there's some of those transportation stocks moving in the other direction.
Michael O'Brien: Yeah, and that's what one would expect to see. And so, as the price goes down, the dividend yield goes up to keep pace with those bond yields. And so, like I say, it's not just the pipeline companies that have been affected, but that's clearly been one of the factors. The second part that's more specific to these companies is, I think for a number of years, we as investors encouraged the pipeline companies to increase their payout ratios, give us more cash, give it back. Investors are fickle. Their mood changes.
And so I think what we've seen over the last couple of years is after the pipeline companies listened to us and did increase their payout ratios, now the focus seems to have pivoted more towards getting your leverage down, reducing your debt. When you have those high dividend payout ratios, it kind of ties the hands of management. It's difficult to do both things at the same time.
And so, TC Energy, which is probably the most topical name in that space right now, not only do they have a bit of an elevated payout ratio, but they also had the misfortune of having some significant cost overruns on some major projects. This has been a long-running theme in the Canadian energy space. So they've had some cost overruns that have put a lot of pressure on their balance sheets. And in response, they're attempting to sell non-core assets or minority interests in some of their core assets.
To date, they've been making progress, but I would say that the valuations they're getting on some of these asset sales haven't been as robust as investors had hoped, so it's putting a lot of pressure on some of those stocks.
Greg Bonnell: Let's broaden that out. If we're talking about stocks that are particularly sensitive to rising bond yields that pay dividends -- and you mentioned them, some of the utilities, the communications. I think if we show some pictures of those in terms of charts, about the movement of yields and the movement of those indices. We might see something similar.
Michael O'Brien: Yeah. Yeah, I was going to say probably you're going to recognize this chart because it looks pretty much the same. So what's interesting, communication services, in other words, your big wireless and telecom providers, BCE (BCE), Telus, Rogers (RCI), similar to what I described with TC Energy, they've got some of their own sector-specific issues and directly in communication services, with Rogers acquiring Shaw, with the Freedom Mobile going to Quebec.
Obviously, there's a lot of anxiety among investors about how the competitive environment is going to shape up for these communication services companies. Is there going to be a wireless price war with back to school? So that's part of the reason why there's been pressure on those stocks.
But if you then look at the utility space, far less hair on those names, and yet it's the same chart. And so that's what brings us back to when interest rates go up, it pressures the higher-yielding dividend stocks that investors have traditionally turned to for yield.
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What Higher Oil Prices Could Mean For Canada's Energy Sector And Investors