2023-09-15 15:38:47 ET
Summary
- E&P stocks trade at depressed valuations compared to other times in their history.
- They could experience explosive upside if today’s valuations re-rate to higher levels.
- While we’re not banking on a bonanza from a multiple re-rating, energy investors should be aware of the possibility.
Seasoned energy investors have been beaten up so many times that optimism can be hard to muster. But that doesn’t mean we shouldn’t consider some unusually bullish cases for our equities. E&Ps, in particular, could undergo a multiple re-rating that pushes their stock prices significantly higher.
A quick comparison of Surge Energy’s ( SGY:CA , ZPTAF ) stock market valuation today vs. 2014 shows that valuation multiples are on entirely different planets. Consider that in 2014, Surge traded at a 6.93% free cash flow yield and a 7.45 multiple of enterprise value to funds from operations.
Today, Surge trades at a massive 22.12% free cash flow yield at $80 per barrel WTI and a lowly 3.34 multiple of enterprise value to funds from operations.
In Surge’s case, applying the 7.45 EV/FFO multiple from 2014 would put its Canadian-listed shares at $26.13. Compare that to where its stock trades today, at $8.62. Applying the 2014 multiple would result in more than 200% appreciation.
Here’s a similar chart for another Canadian small-cap E&P, Bonterra Energy ( BNEFF ).
Bonterra’s stock is selling at a particularly steep discount due to the risk stemming from its high debt load. But a re-rate back to its 2014 multiple would send Bonterra’s stock from today’s $7.48 all the way to $32.61, representing appreciation of a whopping 336%.
The upshot of the valuation gap that exists between today and the more bullish times in the past is that if investor attitudes towards E&Ps shift in a positive direction, the room for multiple expansion is enormous. Moreover, today’s higher oil prices mean that a slide in the opposite direction to a lower rating is not likely.
The situation illustrated with Surge applies to most small-cap Canadian E&Ps. The situation also applies to large caps, though to a lesser degree, as high-quality large-cap Canadian E&Ps currently trade at a much higher multiple than small caps. Cenovus Energy ( CVE ), for instance, trades at a 6.05 EV/FFO multiple at $80 per barrel WTI versus Surge’s 3.34. Still, CVE possesses a substantial valuation discount relative to its 2014 level. Back then, CVE shares traded at an 8.06 EV/FFO multiple and a paltry 2.04% free cash flow yield. At $80 per barrel WTI today, its 2014 EV/FFO multiple would send its Canadian listed shares from today’s $27.86 to $44.42, a 59% return. While the return isn’t on par with Surge and other smaller Canadian E&Ps, it’s not shabby by any means.
We can’t know exactly what event would bring about a multiple re-rating for oil and gas E&Ps. A severe global oil supply outage might do the trick. Or perhaps a shift by investors away from the renewables craze would catalyze a re-rate. It appears we’re already heading in that direction, given the recent news surrounding wind project failures and mounting opposition to new projects from local residents. The electric power emergency unfolding in Texas is also helping to turn popular sentiment against renewables, as the large-scale replacement of coal power plants with wind and solar power installations caused the crisis. When the last bona fide emergency occurred during Winter Storm Uri, renewables proponents blamed rolling outages on natural gas, from freeze-offs and the like. It’s going to be much more difficult to blame gas this time around in the summer.
In any event, serious cracks in the renewables façade have begun to form, and we believe the push to electrify everything will abate once the true costs—financial and otherwise—are understood. As it does, we anticipate a newfound appreciation that oil and gas is here to stay and equity investment in the sector is necessary for ensuring its long-term vitality. In our view, this is the most likely trigger for a multiple re-rating for E&Ps.
Conclusion
Even if a multiple re-rating fails to materialize, improving fundamentals amid higher oil prices should push our favored E&P stocks higher. The shares of Cenovus, Surge, Suncor Energy ( SU ), MEG Energy ( MEGEF ), Canadian Natural Resources ( CNQ ), and Cardinal Energy ( CRLFF ) are all likely to benefit from higher oil prices alone. Still, the optionality of tremendous upside from a meaningful multiple re-rating can’t be ignored. Grizzled oil and gas veterans like ourselves aren’t banking on a bonanza, but we’re well attuned to the possibility that it could happen. As long as the possibility exists, we recommend that energy income investors maintain at least a small exposure to income-producing E&P stocks in the event it comes to pass.
For further details see:
Cenovus Energy: This Variable Can Turbocharge The E&P Rally