Despite the Recent Weakness, TSX Energy Stocks Still Look Strong

Canadian energy stocks have gained 60% this year, while the TSX Composite Index has lost 8%.

Vineet Kulkarni

Vineet Kulkarni joined The Motley Fool Canada in January 2020 and covers multiple sectors and geographies. While North American oil and gas industry is one of his core interests, he often writes about utilities, tech and telecom. Vineet aims to help investors make informed decisions with his fundamenal analysis and insightful research. Apart from being a value investor himself, he is a proud father and a happy husband.

Published June 16, 2022 11:30 am EDT

Though TSX energy stocks have fallen of late, they still seem well positioned for strong growth. Thanks to rallying oil and gas prices, Canadian energy stocks have gained 60% this year. In comparison, the TSX Composite Index has lost 8%.

A lower demand outlook amid the China lockdown and profit booking have weighed on crude oil prices this week. However, the chronic supply snags could send oil prices well beyond US$125 a barrel in the short term.

Apart from the supportive macro environment, here are some of the reasons why TSX energy stocks could keep climbing higher.

Superior financial growth

Higher oil prices directly boost producers’ revenues and margins. As a result, we have seen substantial free cash flow growth and improvement in margins in the last few quarters. Importantly, oil and gas companies have used this excess cash to repay debt, significantly reducing their leverage. Thus, apart from superior earnings growth, the improved balance sheet strength has been behind their recent stock outperformance.

For example, the country’s biggest company, Canadian Natural Resources (TSX: CNQ)(NYSE: CNQ), saw its earnings more than double during Q1 2022. Its net debt has come down from $22.6 billion in 2020 to $14.9 billion at the end of Q1 2022. As a result, CNQ stock has returned 70% in the last 12 months.

Note that oil prices in Q2 2022 have been significantly higher than they were in Q1 2022. So, there is a high possibility of even higher earnings growth and more deleveraging in Q2 2022. Investors could see TSX energy stocks unlocking more value when they report second-quarter earnings.

Surging dividends

Despite allocating a large portion of cash flows to debt repayments and operations, Canadian energy producers are still sitting on a pile of cash. So, the incremental cash will most likely be used for shareholder dividends and share buybacks. That is why we have seen a flurry of dividend hikes and buybacks from Canadian energy in the last few quarters.

Canada’s oil sands giant Suncor Energy (TSX: SU)(NYSE: SU) doubled its dividend last year. This year, the company increased shareholder payouts by 12% after its higher-than-expected Q1 2022 performance. SU stock currently yields 4%, higher than peer TSX energy bigwigs. SU stock has returned 65% in the last 12 months.

Moreover, there is a big scope for more dividend hikes considering better performance in Q2 2022.

Valuation

Even after doubling since last year, TSX energy stocks do not look stretched from a valuation perspective. For example, Suncor Energy stock is trading 11 times earnings while CNQ is trading 10 times earnings. Given the strong earnings growth potential, improving balance sheets, and surging dividends, we might get to see valuation multiple expansion in the next few quarters.

Moreover, even if oil prices come down significantly, there might not be an equivalent fall in TSX energy names. That’s because they are now in a much sturdier financial shape and have a breakeven point close to $40. Also, stable dividends amid uncertain markets and valuation discount will likely keep them resilient.