An interesting take on how high E&P stocks could go

[dan_s]

Scotiabank's take on the Canadian Energy sector dated December 16, 2020

How Much Higher Can Cdn Oil-Weighted Share Prices Go?

OUR TAKE: Neutral. WTI has increased 17% since November 13th, moving from ~US $40/bbl to ~US$47/bbl currently. Over the same time frame, oil-weighted share prices have risen by 31%. So, what if oil prices jump another US$5/bbl - how far can share prices run up from here? We think about 15%-25% for the largest companies, 35%-45% for SMID caps, and 10%-15% for royalty companies.

KEY POINTS
Methodology. We looked at three scenarios to examine how much share prices could
run in a higher oil price environment (+US$5/bbl over the strip). We broke our universe
into three groups, the large caps (mkt cap of >$5B ) and SMID caps (mkt cap of <$5B)
and royalty companies. This simplistic analysis only assumes a change to oil prices and
does not change other variables like cracks spreads (so integrated companies would
have more torque if crack spreads improved as well) or capital spending (which would
lower E&P FCF, but would likely increase the production for royalty companies as E&P
companies' activity increased).

1. Allowed our 2021 cash flow estimates to move with oil prices and kept the yield the
same. The upside using this analysis was huge with the average potential share
price increase of 66% for the large caps, 217% for the SMID caps and 11% for the < My take, for micro-caps like HMENF and IPOOF, the upside is more than 500%.
royalty companies. Although appealing for Canadian energy investors, we think this
scenario is highly unlikely as we expect yields to rise with oil prices. Current 2021E
DAFCF yields (strip) average about ~7%. In our view this is low for E&P stocks and
suggests stock are already pricing in a higher oil price.

2. Allowed our yields to increase by 1% (absolute) with the higher oil price assumption
(+US$5/bbl). The higher yield subdues some of the share price upside, with the
average potential share price upside of 39% for the large caps, 150% for the SMID
caps and ~1% for the royalty companies.

3. Allowed our yields to increase by 2% (absolute) with the higher oil price assumption
(+US$5/bbl). The higher yield again subdues some of the share price upside, with
the average potential share price upside of 19% for the large caps and 99% for the
SMID caps. At a higher DAFCF yield we show an average share price decline of 8%
for the royalty companies due to their lower torque to higher WTI prices.

Relative performance. We also wanted to track the relative performance. For 2020
YTD the oil-weighted companies are down roughly 35%, ranging from 17% to 57%. This
corresponds to WTI prices falling from ~US$61/bbl at the start of the year to US$47/bbl
currently (down ~24%). Looking at a recent shift, where WTI jumped from about US$40/
bbl on November 13 to US$47/bbl currently (up 17%), the oil-weighted stocks increased
by 31%, on average, with a range of 10% to 67%.

FCF Sensitivity. We also reviewed our FCF sensitivity to identify the companies with
the most torque to oil prices (great when oil prices are rising, not so much when they
are falling). Exhibit 6 outlines our FCF sensitivity for the companies in our Canadian
oil-weighted universe. The companies with the highest torque include: BTE, MEG, and
CPG.

Conclusions. We continue to believe the Canadian oil-weighted sub-sector holds value
as we believe the upward movement in oil prices is set to continue, while egress looks
to improve meaningfully with a more subdued production growth profile and additional
egress coming onstream (notably Line 3 Replacement in H2/21). In our view, yields will
increase as oil prices go up, as investors demand more yield given the increased risk of
pricing in a higher oil price scenario. Our best estimate is that the large cap stocks have
about 15%-25% upside if oil prices rise US$5/bbl (implies a 2021 WTI price of US$52/
bbl), while the SMID cap (with more torque) names have 35%-45% upside. We estimate
that royalty companies, which have less torque to oil, have upside of 10%-15%.

Stock Selection: Our stock selections are based on several factors with the biggest
drivers being sustainability (low cost structure, manageable balance sheet and
operational liabilities) and DAFCF yield. Our top picks include:
• Large Cap: SU and CNQ
• SMID Cap: ERF
• Royalty Companies: FRU
• For torque to higher oil prices we would also recommend MEG.

[dan_s]

From CIBC Equity Research:

This year was extraordinarily difficult for the energy sector following the
unprecedented impact of pandemic-related demand destruction and a brief
OPEC+ price war. Given its relative performance vs. the broader index, we
understand why investors have been quick to shy away from the sub-sector.
Looking forward to 2021, we believe that: 1) pandemic-related demand
recovery; 2) OPEC+ supply restraint; and, 3) continued draws of OECD
inventory towards historical norms will, in combination, render the sector a lot
harder to ignore as fundamental momentum should continue. We believe
strengthening prices will drive compelling free cash flow valuations in the
space relative to other industries. Despite the strength in natural gas
fundamentals, we carry an increasing bias towards oil-weighted companies
in 2021. We remain biased towards companies with solid fundamentals,
including strong balance sheets, low sustaining capital requirements, and
above-average free cash flow (FCF) generation.