Crude oil stockpiles have been rising this year, indicating softer demand compared to last year. However, oil has been rallying on a bigger trigger in the last few weeks —OPEC’s big production cut. Oil has recently reached its six-month high, surging 25% since last month. In comparison, TSX energy stocks have rallied approximately 13% in the same period.
The upstream oil and gas sector has been in the limelight since the pandemic. Massive earnings growth and debt reductions have taken investor confidence to the highest levels ever. Interestingly, with a bullish environment on the price front, the sector is likely to see another blockbuster year in 2023.
TSX energy sector continues to flourish
For 2022, Canada’s five biggest energy-producing companies collectively reported $40 billion in profits, astounding 126% growth year over year. In terms of growth, North of the border oil and gas companies even beat their US bigwigs as the latter saw a 118% jump in their bottom lines.
TSX energy companies are well on track to achieve their net debt targets this year and move to the next phase of shareholder returns. Bigwigs aim to distribute around 75%–100% of their free cash flows to shareholders via dividends or buybacks. The latter has been the preferred route for most companies as it offers more flexibility to management.
Canadian Natural Resources (TSX:CNQ), the biggest energy producer by market cap, has been firing on all cylinders for the last few quarters. CNQ has been quite consistent on dividends as well as share repurchases.
In Q1 2023, it bought back 8.9 million shares and raised its quarterly dividend by 20%. The energy major will likely keep buying back shares and fuel investor returns. CNQ repaid almost $4.2 billion of debt last year, taking it to the strongest balance sheet position in years.
Deleveraging and buybacks to remain key thesis
Capital discipline has been the theme in the energy sector since the pandemic. Oil and gas production companies focused on deleveraging, even when higher oil prices hinted at raising production. This has led to further tightness in the markets but at the same time has notably improved the sector’s financial health.
To be precise, the average leverage ratio for energy producers in the pre-pandemic period was around 3x, which has now dropped to around 0.5x. A lower debt balance will trim interest expenses, further improving profitability.
For example, a mid-cap thermal oil producer MEG Energy (TSX:MEG) had net debt of over $3 billion in 2020, which has now fallen to $1.6 billion. Thanks to its rapid free cash flow growth, it managed to reduce its leverage significantly. Interestingly, it will likely save approximately $100 million in interest expenses this year.
Another crucial driver for Canadian producers this year is an expected surge in Western Canadian Select (WCS). It is a Canadian benchmark price for heavy oil at Hardisty. The differential between WCS and WTI widened last year, which notably dented heavy oil producers. However, additional pipeline capacity coming online and much lower releases from the US Strategic Petroleum Reserves will likely trim the differential this year. A narrower spread will likely help Canadian producers like MEG Energy.
Key investor takeaway
TSX energy stocks at large are currently trading seven times 2023 free cash flows. This represents a discounted valuation compared to their historical average.
Undoubtedly, with such earnings growth visibility and historically the best balance sheet positions, TSX energy stocks deserve a higher valuation multiple.
The upcoming Q1 2023 earnings will be a key driver for them in the short term. It will be interesting to see where they land amid higher expected earnings growth and aggressive buybacks.