Canadian energy stocks returned 50% last year, while the TSX Composite Index dropped 8%. Their back-to-back outperformance is quite noteworthy, considering the challenging macroeconomic picture. This year as well, TSX energy stocks continue to look attractive. While their performance might fall short compared to last year, considering current oil and gas prices, they still are well placed to beat broader markets.
Capital discipline
In the earlier high-price environments, energy producers hurriedly deployed capital to increase production to earn more profits. However, this has changed since the pandemic. North American energy producers are sitting at record cash flows, and yet they expect production growth around low single digits.
Note that producers have increased their capital expenditures for 2023 compared to 2022. However, this incremental capital is unlikely to boost production significantly due to higher costs.
Deleveraging and focus on shareholder returns
So, where did the excess cash go?
It went for debt repayments and shareholder returns. On average, Canadian oil and gas producers have paid 40% of their total debt since the pandemic. This has brought them in a much better financial shape and will drive profitability in the next few years. To be precise, TSX energy had a net debt-to-EBITDA (earnings before interest, tax, depreciation, and amortization) ratio of around 2.5 times pre-pandemic, which has now dropped below 0.5.
For 2023, many companies have already achieved their debt target and, thus, are expected to allocate more free cash flow to shareholder returns.
Cenovus Energy (TSX:CVE), Canada’s second-largest energy company by market cap, has repaid nearly $3.7 billion of debt in 2022. It is expected to allocate 75% of its free cash flows to shareholder returns once its net debt falls below $4 billion. At the end of the fourth quarter of 2022, its net debt was $4.3 billion.
Earnings growth
Even if oil prices have come down significantly since the middle of last year, they are high enough to drive producers’ profitability. Moreover, oil and gas producers have the pricing power that maintains their profitability as they pass on the higher cost burden to their customers. This makes their profit margins relatively stable, even in inflationary environments.
Very few sectors have such pricing power. Along with energy, consumer staples and healthcare companies generally hold pricing power.
While broader markets’ earnings grew by 3%, the energy sector’s earnings more than doubled in 2022. With massive share buybacks and declining debt, energy producers might continue to see stellar earnings growth this year as well.
Plus, many Canadian energy producers sell their produce in the United States. So, a stronger U.S. dollar has been an additional factor that’s been driving their financial growth.
Valuation
TSX energy stocks have soared 20% in the last 12 months and 350% since the pandemic lows. However, despite such an epic ascent, they are still trading five times their earnings. They are currently trading at a free cash flow yield of 15%, way higher than their historical average.
The recent drop in energy stocks makes them even more attractive from a valuation standpoint. While their earnings have multiplied, the stocks have come down due to recession worries. The demand-supply imbalance will likely lead to higher oil and gas prices, probably in the second half of 2023. So, although TSX energy stocks seem muted lately, they will likely turn higher and outperform.
