Canada’s pipeline quagmire has bogged down the domestic oil and gas sector even as the rest of the world rides a resurgence in energy stocks.
With the energy transportation system struggling to accommodate existing oil sands supply, Canadian crude is being discounted against global oil prices by the widest margin in five years.
Energy stocks have accordingly diverged from their foreign peers, as investors and the industry both question the point of expanding in a market that cannot handle much in the way of supply growth.
“The entire system is becoming quicksand,” said Rafi Tahmazian, who helps manage about $1-billion in energy investments at Canoe Financial in Calgary.
“Being scared to grow because of a discounted price and a lack of transportation, that’s not something I can compute.”
In August, the Federal Court of Appeal quashed Ottawa’s approval of the Trans Mountain pipeline expansion, adding another serious regulatory hurdle to the long effort to build new export capacity.
The differential between Western Canadian Select and West Texas Intermediate has since risen to more than US$35. The last time the gap was that wide was during the “bitumen bubble” in 2013.
The discount has weighed on investor sentiment. Within the S&P/TSX Composite Index, oil and gas stocks have declined by 5 per cent over roughly the past six weeks.
Globally, the energy sector of the MSCI All Country World Index has risen by about 7 per cent over that same time, as supply constraints and a relatively healthy global economy have lifted crude oil futures. Several energy analysts have begun to contemplate US$100-a-barrel crude oil, which is a price WTI hasn’t hit since 2014.
Canadian oil is likely to remain heavily discounted as long as supply bottlenecks persist and pipeline expansions remain in limbo. The existing pipeline network has no capacity to absorb new supply, and producers are increasingly turning to the more expensive and less efficient option of transporting crude by rail.
On Wednesday, Cenovus Energy Inc. announced a three-year deal to transport about 100,000 barrels a day of crude from Alberta to the U.S. Gulf Coast by rail starting in the second quarter of 2019. Even with the help of the railways, however, inventories are on the rise.
“If things don’t improve quickly, the industry will need to put more thoughts to supply curtailments than supply growth,” Chris Cox, an analyst at Raymond James, said in a recent report.
This makes investing in the oil patch tricky.
Already, the market is starting to indicate that growth plans will not be received warmly, Mr. Cox said. So rather than emphasize expansion, both investors and producers should focus on discipline, he explained.
Combined with considerable infrastructure uncertainty, relatively low valuations may make share buybacks look particularly attractive. Repurchasing shares while shelving growth plans until prices rise may represent the best use of capital.
After all, the market is favourably disposed to buybacks in general. “If ever there was a time that buying back stock would represent a better return on investment, presumably this is it,” Mr. Cox said.
With little aside from buybacks for the sector to cling to, now might seem to be the point of maximum pessimism for contrarian investors, Mr. Tahmazian said.
Valuations are indeed on the low side. However, energy analysts are generally counting on the price differential narrowing closer to longer-term averages.
As such, earnings estimates have not been revised much to factor in lower realized prices for energy producers. If the price gap persists or widens, analysts' earnings forecasts would need to go down, potentially providing a fresh wave of negative sentiment, Mr. Tahmazian said.
“We’re concerned there’s another shoe to drop."
Tim Shufelt