As chill persists, energy set to heat up

The Canadian energy sector is off to a great start: Natural gas prices have rallied strongly over the past few weeks, crude oil prices appear to have found a floor and the Canadian dollar has sold off.

If this continues, 2014 has the potential for a material gain in profitability and cash flow for Canadian oil and gas companies. This is certainly good news for a sector that has underperformed both its U.S. peers and the broader equity market.

Natural gas prices have benefited from the polar vortex, which has bottled in Arctic air across most of the east and Midwest. Temperatures across most of the Lower 48 states have fallen to their lowest levels since the mid1990s.

This has resulted in a 6.4 bcf/d or 13% year-over-year gain in residential and commercial natural gas demand. On the supply side, production has also been impacted by freeze-offs, with volumes recently falling nearly 2.5%.

The increase in demand and decrease in supply means the year-over-year storage deficit is now expected to reach negative 35% to 40% by mid-February.

This has all been very helpful for natural gas prices, which have reacted by gaining more than 50% since early November, setting a new 2.5-year high at more than $5/MMBtu. In Canada, the AECO monthly index for February recently settled at just under $4.50/GJ, a level reached for the first time in nearly four years.

However, a large part of this move has been confined to the front end of the curve as investors have learned from what transpired back in 2010 when a similar cold front only temporarily impacted pricing. Investors in natural gas stocks are taking an equally cautious approach, with gains ranging from only 5% to 15% since November.

Crude oil prices are also benefiting from the cold weather, with WTI oil rising above US$97 per barrel due to greater demand for heating oil. Canadian oil prices continue to trade at a belownormal discount to similar U.S. blends, but differentials have re- cently improved.

Finally, the Canadian dollar has sold off by nearly 6¢ since November. A weaker Canadian dollar is a positive for the energy sector since its revenue stream is in U.S. dollars while its cost structure, for the most part, is denominated in Canadian dollars.

Should the weaker Canadian dollar and current oil and gas prices maintain themselves over the next two months, we estimate Q1 cash flows could post a 15%to-20% quarterly gain, excluding any impact from production increases. In the interim, the recent positive developments in the sector may represent a good opportunity for investors, especially those underweight.