IS NOW THE RIGHT TIME TO PURCHASE ENERGY STOCKS?

Underlying fundamentals are improving, and it’s not time to panic, analyst says

Oil and gas equities have been underperforming crude oil prices since the middle of 2017, but the outlook for energy stocks deteriorated further in the past two weeks, as major oil benchmarks have declined more than 10 per cent.

That leaves investors wondering whether now is the time to be buying, or is a more cautious strategy warranted?

After peaking above US$66 per barrel on Jan. 25, WTI has slipped nearly 12 per cent to below US$59. The S&P/TSX Capped Energy Index is down 14 per cent during that same period, but more importantly, the Canadian energy equity benchmark never experienced the big rally off the summer 2017 lows that crude did.

WTI surged as much as 55 per cent after dipping below US$42 in June. The TSX energy index only climbed about 23 per cent.

With valuations for oil and gas stocks approaching decade lows, BMO Capital Markets analyst Randy Ollenberger believes opportunities are emerging.

“We do not think it is time to panic,” he told clients, noting that while oil prices have weakened on the prospect of rising interest rates, underlying fundamentals are improving, and it is unlikely that oil falls below US$50 per barrel.

Consensus estimates indicate that the Canadian oil and gas group is trading at a 5.1x forward EV/EBITDA multiple, and the U.S. group is at about 5.6x. That represents the largest discount to the overall market in the last 10 years.

“Investor exposure to the North American oil and gas group is at multi-decade lows,” Ollenberger said. “In our opinion, these valuation levels are attractive relative to historical trading ranges and the overall market.”

While the surge in oil prices was largely the result of heightened geopolitical risk in Venezuela, Saudi Arabia, Iran and Iraq, the pullback can be attributed to ongoing concerns that more crude could be produced than the market can absorb. The ability of U.S. producers to add more drilling rigs at higher oil prices appears to be what’s put a ceiling on gains in crude.

On Tuesday, the International Energy Agency reiterated the clear message it made a month before: The rapid rise in nonOPEC oil production, led by the U.S., is likely to grow by more than demand in 2018.

“For now, the upward momentum that drove the price of Brent crude oil to US$70 per barrel has stalled; partly due to investors taking profits, but also as part of the corrections we have seen recently in many markets,” the IEA said. “Most importantly, the underlying oil market fundamentals in the early part of 2018 look less supportive for prices.”

While many attribute the recent oil price pullback to broader market turbulence, RBC Capital Markets analyst Michael Tran believes there is more going on.

“Oil prices needed a breather and investors should not discount the caution signs that have been emerging,” he said in a report. “In our view, the market has been overly focused on the race toward rebalance without realizing that transient pockets of oversupply have been emerging in the physical market.”

It has become clear in the past year that the market’s ability to absorb oil is heavily dependent on the pace of U.S. production. This factor took a back seat during the oil price rally in recent months, but with production growth of nearly 850,000 barrels per day since late in the summer, U.S. oil producers have demonstrated how aggressive they can be in a rising price environment.

“The market simply got too bullish without pausing to consider the response of U.S. shale,” Tran said, noting that domestic producers continue to see shale flourishing with oil in the midUS$50 range.

As a result, investors should expect these producers to stick with the “drill baby drill” approach, irrespective of volatility in prices, as they continue to lock in price protection through hedging programs.