Keystone XL looms over Canada’s energy shares

Canadian energy companies are the great unloved.

They may be responsible for sparking growth in an otherwise moribund Canadian economy, keeping unemployment down in places such as Alberta, and providing dirt-cheap feedstock to other sectors, but they remain the embarrassing uncles at the party.

The Organization of Petroleum Exporting Countries may be quaking in its boots at the sight of Canadian oil sands companies flexing their muscles and the sheer breadth of ambitious projects planned and proposed, but that is no consolation for investors who have yet to see share prices strengthen.

With the wider S&P 500 energy index galloping ahead to post doubledigit gains in the first half of the year, the S&P TSX capped energy index was down 1.99% during the period, even though virtually every other metric was pointing north.

Even though the overall U.S. market is overvalued, Morningstar Inc. sees the North American energy sector trading at only 86% of fair value.

“I would hesitate to talk about the next six months, but someone looking to building a long-term position, the energy sector is actually the most attractive from a valuation standpoint,” said John Gabriel, ETF strategist at Morningstar.

Canadian heavy crude benchmark Western Canada Select was up nearly 22% in the second quarter alone to average $78.29 per barrel — its strongest showing in five quarters.

The dreaded discount on Alberta crude — guilty of robbing the Canadian economy of as much as $15-billion in revenues according to some estimates — was cut by more than half in the first six months of the year.

North American natural gas prices have also soared, at one stage rising 25% around April before coming back to earth to finish largely flat for the first half of the year.

The momentum and record oil production across North America is cold comfort for investors who have yet to see any of the good news translate into higher stock prices.

A key reason for the energy stocks dragging their feet is the looming shadow of the 1,897-kilometre Keystone XL pipeline.

This could partially explain why iShares’ Oil Sands Sector fund was North America’s worst-performing energy exchange-traded fund in the first half, down 18.48%.

The fund was weighed down by Suncor Energy Inc. (down 5.23% in the first half of the year), Imperial Oil Ltd. (down 6.04%) and Cenovus Energy Inc. (down 9.88%), which together make up a third of the holdings. Among other top producers, only Canadian Natural Resources Ltd. was an outlier with a 3.52% gain during the period. The portfolio manager declined a request for comment.

The U.S. State Department is expected to decide on Keystone XL later in the year and its approval or disapproval will impact the future of the Canadian energy sector.

But investors will have to wait a little longer as the department continues to review the million comments it received after releasing the draft environmental assessment impact report and prepares a final report to determine the fate of the TransCanada Corp. project that would run from Hardisty, Alta., to Steele City, Neb.

“There is always political risks with such [projects], and that’s some- thing that is harder to value,” said Chris McHaney, portfolio manager at BMO Asset Management Inc., who manages a number of energy funds.

The “uncertainty surrounding Keystone XL hangs in the air like a storm cloud,” noted Greg Pardy, analyst at RBC Dominion Securities Inc., after a meeting with five hedge-fund managers in New York.

While Keystone XL remains a question mark, other catalysts may help move the needle. The revamped BP Whiting, Ind., refinery will help alleviate price pressures, although the injection of 110,000 barrels per day by Imperial Oil from its Kearl project in Alberta later in the year could constraint the infrastructure once again.

Enbridge’s 585,000-barrel-per day Flanagan South pipeline is also likely to improve the pricing regime governing Canadian heavy oil from the mid-continent to the Gulf Coast, Mr. Pardy advised clients.

Another catalyst could be the second-quarter results, which start trickling in next week.

“The profit outlook is beginning to stabilize in the all-important energy sector (25% of the 120 S&P/TSX), where 12-month forward earnings estimates have gained upward momen- tum,” said Stéfane Marion and Matthieu Arseneau, analysts at National Bank Financial and are advising clients to go overweight on energy.

Other analysts expect flat production growth because of planned shutdowns and the recent Alberta flooding, although higher commodity prices may help some companies.

Calgary-based investment dealer Peters & Co. is forecasting “aboveaverage quarterly results” from Crescent Point Energy Corp., Devon Energy Corp., Husky Energy Inc. and Imperial Oil, while Suncor and Talisman Energy Inc. may post weaker results as both companies had production issues.

Barclays Capital expects positive surprises from Canadian Natural Resources Ltd., Canadian Oil Sands Ltd. and MEG Energy Ltd. Despite price-induced improvement on the bottom line, the Canadian investment environment remains “tepid,” according to Barclays Capital analyst Grant Hofer.

The sector continues to be out of favour given the continued risk of widening differentials for both oil and gas.

“This has been exacerbated by the weak M&A market, which we believe is a function of limited capital availability and the seeming lack of interest from foreign buyers,” Mr. Hofer explained.

Canada has nearly US$17-billion worth of upstream energy deals in the pipeline — the second highest in the world after the United States — according to research by Houston-based PLS Inc. But recently state-owned foreign investors have cooled off on oil sands companies after the federal government imposed stricter regulations on majority ownership.

“Without an M&A angle, which typically supports valuations in trough periods, the sector appears to be squarely focused on the approval of Keystone XL to provide a muchneeded improvement in sentiment,” said Mr. Hofer.

Other factors such as less-than-robust Chinese demand for crude may also hurt sentiment.

While prices remain high on account of the risk premium in the Middle East, RBC Capital cuts its price estimate for WTI by a dollar this year at US$96 and by two dollars in 2014 at US$97.

Ironically, rising North American oil production will play a key role in keeping a lid on rising prices, which in turn could stamp out any growth spurts in the energy sector.

A Keystone-like catalyst — with a decision going either way — would probably help investors reassess the sector.

A rejection of the pipeline “will cause analysts to re-examine the sector and may apply different assumptions going forward,” Mr. McHaney said. “That could lead to different price targets.”