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Oil and gas companies are seeing enormous profits as crude oil prices are soar and energy demand worldwide surges.Jeff McIntosh/The Canadian Press

The revival of the energy sector puts many Canadian investors in a tricky spot.

Purging their portfolios of fossil fuels was an easy call when oil and gas stocks were the market’s biggest duds.

But now, crude oil prices are soaring, surging energy demand worldwide has supplies running short and the oil patch is raking in enormous profits.

“It’s much more difficult for investors to hold to their same standards when energy is ripping,” said Les Stelmach, senior vice-president and portfolio manager at Franklin Templeton Canada. “Now, it’s costly to not be in the sector. If you get that for a while, investors will have to come back to the space because there will be such a performance gap.”

As the urgency around climate change has grown in recent years, the divestment movement has gained traction. Investors big and small have retreated from high-carbon sectors – part of a global campaign to accelerate the transition to green energy.

Many of Canada’s big pension funds have made net-zero pledges, while the Caisse de dépôt et placement du Québec said in September it will sell all of its oil-and-gas holdings by the end of the year.

There are lots of investors out there who wish they divested from the oil sands even earlier – years earlier.

From its peak in 2014 up to the fourth quarter of 2020, the energy component of the S&P/TSX Composite Index lost more than 80 per cent of its value. Up to that point, energy was the single worst performing TSX sector in five out of the previous seven calendar years.

“The environment was just not conducive to profitability,” said David Sherlock, chief investment officer at SAGE Connected Investing in Calgary. “Throw the politics and the policy on top of it, and it was just no-touch.”

By the time the pandemic hit, Mr. Sherlock said he had moved his clients’ money out of the oil and gas sector altogether.

Fortunes began to change around the end of 2020. Having weathered the worst of the pandemic, the oil patch emerged leaner just as oil prices began to rise. The big players were in a position to scoop up cheap assets.

Canadian Natural Resources Ltd., for example, purchased Storm Resources Ltd. for $960-million in a deal that closed late last year, in addition to picking up Painted Pony Energy Ltd. for $461-million in 2020.

“You’re looking at a de-levered, ultralean, cash-flow machine paying a growing dividend, buying back shares and bringing down debt,” Mr. Sherlock said. In CNRL’s most recent quarterly results, it reported free cash flow generation of $2.2-billion – nearly five times the level from one year prior. And the company raised its dividend by 38 per cent last year.

On a sector basis, energy has gone from worst to first on the TSX, having gained 42 per cent last year. And it’s already increased by an additional 23 per cent so far in 2022.

Profits for the sector have mostly kept pace with the run-up in share prices, meaning valuations haven’t moved up a whole lot, Mr. Stelmach said. Canadian exploration and production companies are still cheap, with valuations roughly half their long-term averages, judging by enterprise value to cash flow, he added.

Much of the energy sector’s comeback has to do with oil prices, which seem destined to break through the US$100-per-barrel mark for the first time in nearly eight years.

Barring a major global economic setback, oil prices will march higher until they reach a level of “demand destruction,” Michael Tran, an energy market strategist for RBC Dominion Securities, wrote in a report. “It simply does not get more bullish than that.”

And yet, having repelled investors for so long, the energy sector now has a widespread underinvestment relative to its size, which is about 15 per cent of the S&P/TSX Composite Index.

The top 30 Canadian equity mutual funds currently allocate just 10 per cent of their assets to the energy sector, on average, according to a recent ATB Capital Markets note.

Fund managers with low energy exposure will take a hit, Mr. Stelmach said.

“Some have made [divestment] an absolute priority and they’re not going back. Others may have left themselves room to pivot.”

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