Disillusionment over the U.S. shale oil boom is leading Wall Street to reconsider an alternative that was largely abandoned by American energy investors – the Canadian oil sands.
After years of pursuing growth at virtually any cost, U.S. frackers, which use horizontal drilling techniques to tap shale deposits unavailable through conventional drilling, have seen investors lose patience in recent months over excessive drilling, well performance issues and a lack of profits.
With many investors now demanding U.S. shale companies prioritize free cash flow and returning money to shareholders, suddenly Canadian producers don’t look half bad by comparison, said Dane Gregoris, senior vice-president of capital markets at RS Energy Group in Calgary.
“Oil sands producers are ahead of the game [regarding] this slow-growth mantra that’s now affecting U.S. shale.”
Analysts at Goldman Sachs recently pointed to the oil sands as “screening favourably” relative to U.S. peers, citing attractive free cash flow and dividend yields.
That echoed the thesis of Merrill Lynch analysts, who said in a research note in September: “We maintain our preference for Alberta (oil sands) over Texas (shale).”
Investors, however, do not appear to have followed that advice in any substantial way. Though Canadian energy stocks as a group have meaningfully outperformed the U.S. sector over the past year, domestic exploration and production (E&P) companies are still trading close to 20-year lows.
“That trade has been a widow-maker for the last several years,” said Brian Madden, a portfolio manager at Goodreid Investment Counsel. “There are still a lot of problems with Canadian oil.”
Those problems include a shortage of transportation options, as pipeline capacity is scarce and crude by rail serves as only a partial solution.
Chronic delays in divisive pipeline developments prompted the province of Alberta to impose mandatory production cuts on the sector, which are still in place.
And the oil sands is increasingly targeted by the global divestment movement, which aims to cut off money to fossil fuel industries as a way to combat climate change.
This week, the largest pension fund in Norway said it sold its holdings in four Canadian energy stocks – Cenovus Energy Inc., Suncor Energy Inc., Imperial Oil Ltd. and Husky Energy Inc. – as part of a full exit from the oil sands. The fund, known as KLP, likened production from the oil sands to coal in terms of environmental impact.
Global institutional investors are increasingly incorporating environmental and social considerations into their investment processes.
“The oil sands isn't perceived to fit that bill. There is a lot of reputation repair that needs to be done,” said Morgan Kwan, a vice-president at RS Energy Group.
Domestic investors have also found plenty of reasons to flee from the oil sands, as many of them shifted their energy exposure south of the border as the shale boom gained strength.
“U.S. shale siphoned a lot of investment dollars out of Canadian E&Ps,” Mr. Madden said.
In the wake of that exodus, the oil patch has been forced to undergo a restructuring.
Unlike their U.S. counterparts, most oil sands producers have largely lost the option to expand output, because of pipeline constraints and curtailment. They’ve had little choice but to consolidate, pay down debt, reduce expenses and increase dividends and share buybacks.
“They’ve had to strengthen their business models and capital structures,” said Patrick O’Rourke, an energy equity analyst at AltaCorp Capital. “By and large, the weakest business models have been flushed out of the system.”
Many of the companies that remain can generate substantial free cash flow at today’s oil prices, and in some cases, pay double-digit dividend yields.
Typically, a yield that high is a sure sign of an impending dividend cut.
“Given the numbers today and their balance sheets and how much money they’re making, they don’t need to cut their distributions,” said Bill Harris, a partner and a portfolio manager at Avenue Investment Management in Toronto.
And yet, alluring yields and valuations plumbing record depths do not yet seem to have won the oil sands many converts, American or Canadian, Mr. O’Rourke said.
“The business models themselves look good. The valuations are compelling. I don’t think investors are quite there yet. But when they are, there’s going to be a lot of opportunities.”