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Avoid the Fallout in the Energy Patch With These 3 Companies

Growing instability in the Middle East and the increasing global demand for energy created an oil shock earlier this year, which many analysts thought would push the price of crude higher.

But the impact of that oil shock quickly dissipated and crude prices plunged, with West Texas Intermediate now trading at well below US$100 per barrel.

How does the U.S. shale oil boom impact global oil prices?

This can be primarily attributed to growing U.S. oil production, with the shale oil boom pushing U.S. crude production higher. It has now overtaken Saudi Arabia to become the world’s largest producer of crude. North American refining markets are now awash with light sweet crude pushing the price of WTI ever lower, and a supply glut is set to grip the market.

It is also having a direct and significant impact on Canada’s energy patch because the U.S. is Canada’s biggest energy export partner. Besides causing softer WTI prices, growing U.S. crude production is causing the price differentials between Canadian crude blends and WTI to widen.

The price differential between Canadian light crude or Edmonton Par has widened to 10% after narrowing to as low as 3% earlier this year, while for heavy crude (West Canada Select), it has grown to a 24% discount after narrowing to as low as 13% earlier this year.

I expect to see these price differentials widen further, with U.S. crude production continuing to grow and Canada’s pipeline crunch preventing players in the patch from accessing vital U.S. Gulf Coast refining markets.

This doesn’t bode well for the profitability of players in the patch as the U.S. is the key export market for Canadian crude.

What are the best opportunities for investors?

With U.S. refining markets set to be awash with light sweet crude, players in the patch without access to other refining markets will be the most adversely affected. Smaller players like BlackPearl Resources Inc. (TSX: PXX) and those with internal problems such as Penn West Petroleum Ltd (TSX: PWT)(NYSE: PWE) will suffer the greatest impact.

These companies are not in a position to absorb any sustained downturn in crude prices because of weak balance sheets and the need to maintain cash flow for investment in the development of existing oil assets to grow production. The larger integrated energy majors are better positioned to deal with declining U.S. demand for Canadian crude, softer oil prices, and widening price differentials.

This makes players like Suncor Energy Inc. (TSX: SU)(NYSE: SU), Canadian Natural Resources Limited (TSX: CNQ)(NYSE: CNQ), and Husky Energy Inc. (TSX: HSE) my preferred long-term investments in the patch. Each has a wide range of geographically diversified onshore and offshore assets including light and medium crude, heavy crude, and bitumen.

More importantly, they can access a range of refining markets, including those in Europe, giving them access to premium Brent pricing, which is important considering this premium is expected to grow as more U.S. light sweet crude hits refining markets. This will help to boost their revenues and profitability even in an operating environment where WTI prices are softening.

But more importantly, their integrated operations — including upstream (oil exploration and production) and downstream (refining and marketing) — allow them to more effectively manage price spreads and their margins.

Those companies that are solely focused on upstream operation onshore oil production in Canada like Crescent Point Energy Corp (TSX: CPG)(NYSE: CPG) are particularly vulnerable to softer WTI prices. In Crescent Point’s case, this vulnerability is exacerbated by its need to continue growing cash flow as an integral part of its dividend plus growth operational model.

The three integrated energy companies also continue to pay dividends with conservative payout ratios, which means there is significant fat to absorb any sustained downturn in crude prices.

Suncor has a tasty yield of 2.4% and a very sustainable payout ratio of 43%, whereas Canadian Natural Resources’ dividend yield is a less than impressive 1.8% though the payout ratio is a mere 30%. Of the three, it is Husky that has the highest dividend yield at 3.7%, though it also has the highest payout ratio at 60%. I believe the dividend is still sustainable.

Suncor, Canadian Natural Resources, and Husky are important additions to any portfolio because they have the ability to continue rewarding investors even in the event of a sustained downturn in crude prices.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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