Investors should look beyond current oil prices when making decisions
Investors in the Canadian energy sector have certainly felt the pain of plunging oil prices, as the S& P/ TSX Energy Index is down more than 25 per cent since June 2014, but some say things could be worse.
Oil has fallen roughly 60 per cent during the same period, after peaking near $ 107 US per barrel, yet Canadian Natural Resources Ltd., Suncor Energy Inc. and other names in the benchmark Canadian energy index are still trading at a lofty 65x forecasted fourth- quarter earnings.
That level, Bloomberg reports, is at an all- time high and more than double the average of their U. S. counterparts. One analyst said the sector is reflecting oil prices closer to $ 60, while another considers Canadian energy stocks overvalued if prices don’t climb above $ 70.
But don’t dump your energy stocks ( if you still have any) just yet, because comparing equity prices to spot crude isn’t the only metric that matters.
Menno Hulshof, an energy ana- lyst at TD Securities, said the focus on spot WTI oil prices to measure the relative performance of the Canadian energy index is misguided.
He considers the relative performance of the index versus oil futures a more appropriate measure, because it better aligns oil price expectations with reserves, a key factor for the long- life nature of many energy assets in Canada, particularly the oilsands.
“Although the relative performance of spot WTI oil prices and the index is a logical starting point, it clearly does not tell the full story,” Hulshof said.
Although the energy index is outperforming oil by a healthy margin, it has declined as much as the 12- month forward oil price curve, and 18 per cent more than the 36- month forward curve. Clearly Canadian E& Ps haven’t been as resilient as many think in the face of collapsing oil prices.
Hulshof makes a case that a floor has already been established for Canadian energy valuations unless there is another meaningful pullback in prices at the back end of the forward curve. These pricing dynamics also reduce the probability that stocks collapse with spot prices if, for example, surging oil production were to test the limits of U. S. storage capacity.
Of course, the correlation between share prices and oil varies from firm to firm. That’s a good reason to use net- asset value estimates, since they better reflect commodity price movements and various structural changes that can emerge, including things such as royalties and taxes.
Looking at WTI prices and energy stock performance on a sub- sector basis also supports the notion that most, if not all, of the correction due to crashing oil prices is already reflected in equities. The returns of each of the juniors, intermediates, seniors, integrateds and internationals have fallen more than their NAV estimates.
It’s also worth pointing out that Hulshof found that the dip in the energy index and his NAV estimates generally mirrors changes to the latter part of the 12- month oil futures contract, not the near month.
WTI back in June was above $ 105 per barrel, and the back end of the curve was somewhere around $ 87. Now the curve is in contango, as spot prices are near $ 45 and the back end of the curve is around $ 66.
Since energy producers are more concerned about the average price of oil over a long period of time, not just where it is today, so too should investors look beyond spot prices when deciding whether now is a good time to sell, or buy for that matter.