There are several reasons why the Canadian energy sector is hot today. Apart from high oil prices, falling debt levels and earnings visibility is what makes these stocks investment-worthy.
What TSX energy stocks are outperforming?
As a result, since the pandemic, TSX energy names have returned a massive 300%, while the TSX Composite Index returned 50%. Although that seems like a substantial outperformance, it is still dwarfed when compared to some mid-cap energy names.
For example, the $6.5 billion MEG Energy (TSX: MEG) stock has returned 1,375% in the last three years. Its stellar earnings growth, along with rapid buybacks, has resulted in such noteworthy outperformance. But will it keep the momentum?
Let’s see what’s next for MEG Energy stock.
MEG produces thermal oil using the SAGD (Steam-assisted Gravity Drainage) method that has significant exposure to the domestic benchmark Western Canadian Select (WCS). The differential between WCS and WTI has widened since last year, mainly due to lower demand from the US. However, as the US is expected to refill its Strategic Petroleum Reserve this year, the differential could again narrow. This will likely be a big growth driver for MEG, leading to higher realized prices and margins.
MEG Energy: WCS-WTI differential
MEG expects this differential to tighten soon. Currently, the differential is approximately US$7 per barrel, higher than the historical average. If it reverts to the long-term mean, which is around US$15 a barrel, it will add $315 million to the company’s cash flow. This will accelerate MEG’s debt reduction and shareholder returns.
The thermal oil producer aims to produce 105,000 barrels of oil per day in 2023 with a capital expenditure of $450 million. It is currently allocating 50% of its free cash flows to deleveraging and the rest to shareholder returns. This strategy is expected to improve the company’s balance sheet as well as drive investor returns.
At the end of Q4 2022, it had net debt of $1.6 billion, significantly down from over $3 billion in 2020. Even though its leverage has fallen, MEG still focuses on bringing the net debt down further. The leverage ratio has come down to 0.8x as of Q4 2022 from 5x in 2020.
A potential 100% allocation of excess cash to shareholder returns
It expects to allocate 100% of its free cash flows to shareholder returns if it reaches a net debt target of US$600 million. According to the company, if oil prices average around US$100 per barrel this year, MEG will reach those debt targets by the end of 2023. This could soon trigger the next phase of shareholder returns, which will probably begin with a dividend.
That’s still a distant dream. But it definitely indicates on which path the company is going. Moreover, a focus on shareholder returns and debt reduction highlights the management’s clarity over its excess cash deployment.
Another aspect where MEG stands tall is valuation. MEG stock is currently trading at seven times its earnings and seven times free cash flows, while oil currently trades at US$80 a barrel. MEG stock offers a 15% free cash flow yield—a very attractive investment proposition.
Bottom line
MEG Energy’s solid operational and financial performance will likely create shareholder value for the next few years. High oil prices amid an improving balance sheet make it more attractive. Moreover, aggressive buybacks, along with superior earnings growth, might fuel handsome investor returns.
