Strength in both the Canadian stock market and in global crude oil can't fix what's wrong in the oil patch.
Canadian oil and gas stocks collectively are proving to be the listless exception as domestic equities trade close to record territory and global oil prices are just off of three-year highs.
Despite the favourable environment, the kind of heavy crude extracted from the oil sands has recently become deeply discounted as a result of a shortage of spare pipeline capacity.
A pipeline bottleneck combined with surging Canadian production is forcing more producers to rely on rail – an extra cost that has been abundantly passed through to share prices.
Faced with a long-term transportation issue, the sector is not likely to see investor sentiment substantially improve any time soon, said Rafi Tahmazian, a portfolio manager at Canoe Financial in Calgary.
"You have to assume lower valuations for the sector than historic averages. Our stocks just won't trade as high as in the past," he said.
Not only will those sector woes take a toll on Canadian stocks in general, but investors will have to carefully consider a company's ability to get its product to market when weighing individual stocks, Mr. Tahmazian said.
For at least the next couple of years, relatively cheap Canadian oil could mean underperforming Canadian energy stocks.
In general terms, the Canadian crude benchmark, called Western Canadian Select (WCS), is priced cheaper than its U.S. counterpart, West Texas intermediate, because of the need to ship to U.S. refineries, as well as the additional cost of processing the heavy oil.
But in December, the differential between heavy and light crudes widened dramatically as a result of space rationing in the Canadian pipeline network.
The gap between the two benchmarks increased to a four-year high of almost $27 (U.S.). While some of the factors fuelling the differential were temporary, such as the closing of TransCanada Corp.'s Keystone pipeline after a major spill in South Dakota, WCS remains discounted by about $25.
The pipeline crunch is being made worse by additional production coming online, primarily from Suncor Energy Inc.'s $17-billion Fort Hills mine, which is targeting output of 190,000 barrels per day of bitumen by late 2018.
"The additional heavy oil supply from this project will be running up against effectively full export pipelines and [will be] forced to move on the rails," Martin King, an analyst at GMP FirstEnergy, wrote in a recent note.
Rail transportation is about twice as costly as moving crude by pipeline. As a result of the additional cost, "differentials will need to remain wide for the foreseeable future," Raymond James analyst Kurt Molnar said in a report.
And relief from additional pipeline capacity is not expected until late 2019 at the earliest.
The domestic oil glut came about just as oil globally rose to its strongest level since crashing in 2014. Since early September, U.S. oil futures rose by 30 per cent to surpass the $62 mark on Thursday for the first time in four years. Over that same time, Canadian crude has been flat at about $36.50.
On the gas side, a similar set of problems is emerging. The ambitious growth plans of several producers in Western Canada coincide with limited options in moving that new production, Mr. Molnar said. "We struggle to see a sufficient case to see a more constructive gas market emerging, at least over the course of 2018."
The toll on domestic equity performance has been clear. Over the last year, energy is the only sector within the S&P/TSX composite index in negative territory, having declined by nearly 10 per cent over that time.
While it's true that the sector has improved since mid-August, when the global crude market started to strengthen, the domestic stock gains are nowhere near those posted by the U.S. energy sector – 22 per cent vs. 11 per cent.
In this kind of environment, picking domestic oil and gas stocks becomes more complicated than simply identifying the best positioned sub-sector, Mr. Tahmazian said. For any individual company, profitability is much more affected by constraints in transporting their product, he said.
But lighter crudes might be less affected than heavier ones by the price differential, Mr. Tahmazian said. On that note, he identified Crescent Point Energy Corp. and Torc Oil & Gas Ltd. as potential winners.
Among larger producers, Imperial Oil Ltd. has a higher reliance on rail transportation, making it among the most sensitive to the discount on heavy oil, according to BMO Nesbitt Burns Inc. analyst Randy Ollenberger. Suncor Energy Inc., meanwhile, is the least sensitive given its broader asset base, Mr. Ollenberger said.
Beyond late 2019, some large export pipeline developments could help narrow the discount on WCS, including Keystone XL, Kinder Morgan Inc.'s Trans Mountain proposed line to the West Coast, and Enbridge Inc.'s replacement and expansion of Line 3 to the U.S. Midwest.
But the domestic energy industry faces a larger problem, in that it essentially has a single buyer that is on track to eventually become a net energy exporter, Mr. Tahmazian said.
"There's a global market and we can't get to it."