THE HEDGEYE EDGE
Investors have left Canada and its oil sands for dead. Massive local discounts, a ~35% drop in WTI during the 4th quarter, and a suffocating regulatory environment culminated in the prevailing narrative that Canadian oil is simply “uninvestable.”
However, our research shows the market is overlooking certain characteristics of Canadian Natural Resources’ (CNQ) low-cost 1MMboe/d production base – given the macro overhang, the risk/reward is deserving of a second look.
CNQ is the largest non-integrated E&P in Canada by market capitalization and the second largest oil sands miner by capacity. The company is also the 2nd largest heavy oil producer in Canada and the largest natural gas producer in Canada.
After a 10+ year investment cycle, CNQ’s asset base is extremely efficient, high margin, and diversified with a solid balance sheet. It generates free cash flow in nearly any commodity price environment. At normalized differentials CNQ’s oil sands mines have better economics than nearly all shale oil-levered E&Ps.
On a full-cycle basis, CNQ’s upgraded mining operations have one of the highest FCF profiles in North America. In 2018, the company earned ~C$5.5B in FCF paid ~C$1.6B in dividends, reduced debt by ~C$1.8B (net of USD gross up), and repurchased C$1.2B of stock. The company reaffirmed 2019 CapEx and production guidance, increased the quarterly dividend by 12%, and maintained it’s 50% debt reduction / 50% share buyback capital allocation policy. By our estimates, CNQ is one of only a handful of oil-levered upstream businesses that generates FCF at $50 WTI.
Meanwhile, three serious problems have plagued Canadian E&Ps:
- Explosive production growth,
- Tight pipeline capacity, and
- A hostile political environment
But there are signs of an inflection. Canada’s exponential production growth cycle is likely ending despite forecasts of perpetual high single-digit expansion. The last (ever?) oil sands mine is online. In-Situ production growth is stalling with wide differentials and minimal expansion CapEx. Near-term, differentials should ease. Days of crude supply in Alberta, the best proxy for future differentials, have normalized after the most vicious refinery turnaround cycle in 3 years.
Political opinion and polling data are degrading on the margin for the current administration as pressure mounts for real regulatory change ahead of a re-election cycle. In other words, the odds of a longer term solution look improved as the regulatory environment becomes better than awful. The Canadian populace is showing signs of fatigue with the current administration.
CNQ’s valuation is attractive. Current metrics are pricing in ~$40 WTI or $50 WTI with blown out differentials indefinitely. The dividend is safe, the yield is +4% relative to the S&P 500 at ~2%. In our view, things cannot get much worse for CNQ and the current macro backdrop has created an opportunity to own one of the highest quality E&Ps in North America at its most compelling risk/reward in a decade.
Based on our DCF and comp multiples valuation frameworks, we estimate Fair Value for CNQ to be C$45 - C$50 /share (25% - 40% upside).
ONE-YEAR TRAILING CHART
