Energy Prospectus

The notes below are from Jon Costello at HFI Research

At a press conference on Thursday and again earlier today, President Trump announced that he would decide whether to place tariffs on Canadian crude imports. Tariffs on oil are not our expected case due to their impact on the U.S. energy industry and the energy prices paid by consumers. Nevertheless, we have to acknowledge that they’re a possibility and respect the fact that betting markets and stock markets are discounting some degree of tariffs.

There is some confusion about whether tariffs will be implemented on February 1 or March 1, as reported by Reuters. However, the CBC reported more recently that the deadline remains February 1 and that oil and refined products won’t be exempt. Either way, we’re on the lookout for buying opportunities if and when tariffs come to pass.

Tariffs Would Harm the U.S.

Our basis for doubting the imposition of tariffs is simply to recognize that Trump may be wily and come across as crazy at times, but he isn’t stupid. Tariffs on Canadian oil imports would be a stupid move on many levels.

A scenario in which 25% tariffs are implemented on Canadian oil imports is a frightening one for U.S. consumers and the U.S. economy. The impact would deliver a blow to US refiners, particularly those in the land-locked Midwest that were built to process Canadian heavy crude. To avoid paying up for Canadian heavy oil feedstock and producing refined product output at an uncompetitive price, U.S. refiners would attempt to meet their heavy oil requirements through foreign imports, straining the import capacity at the U.S. Gulf Coast and making the U.S. more reliant on countries that the Trump administration has in its crosshairs, such as Mexico and Venezuela. Canadian inventories could fill up. In response, the Albertan government could mandate supply curtailments, which would push heavy oil prices higher in the U.S. by reducing supply and narrowing the WCS-WTI spread.

Refineries would max out their throughput of lighter barrels, which could push WTI higher because inventories at the Cushing hub are extremely low. Eventually, increasing WTI prices would feed through to higher gasoline and diesel prices, angering voters. Depending on how high gasoline prices go, the surge could raise concerns about a recession, as past recessions tended to be preceded by a spike in oil and gasoline prices.

Politically, tariffs’ negative impact on the U.S. would make Trump look silly on the global stage. It would hurt his favorability rankings in the polls and cause voters to question his commitment to maintaining low energy prices and a strong economy. It would also damage the electoral prospects of incumbent Republicans.

If a lesser tariff of, say, 10%, were imposed, it would take longer to work its way through the system, but it would still have the negative impact described above.

The tariffs would hit the Canadian economy hard, forcing the lame-duck and currently ineffective Canadian government to act on Trump’s peeves about illegal border crossings and fentanyl smuggling. < MY TAKE: It seems to me that this is a reasonable thing for Trump to ask of the Canadian government.

We wouldn’t expect tariffs to last long. Once they are repealed, all Canadian E&Ps stock prices would snap-back. Even the highest-quality names would sell off if Trump does impose the tariffs. Opportunities to buy the highest-quality energy stocks at a discount don’t arise often, so this tariff imbroglio presents an outstanding long-term buying opportunity.

Jon's Picks:

A Rare Opportunity to Buy Quality
One of the juiciest opportunities will be shares in companies whose stocks tend to be relatively insulated from macro-related downside due to the high quality of their business. In an environment of heightened fear, even these stocks would be sold by skittish shareholders and others who will sell the shares short.

My first high-quality pick would be Canadian Natural Resources (CNQ). Among the larger North American independent oil and gas producers, CNQ has the best acreage, longest reserve life, and best economics. Its stock trades at a nearly 10% free cash flow yield, which will grow with higher oil prices and production growth. CNQ has minimal debt and the lowest operational and financial risk in the sector.

CNQ shares would suffer under a harsh tariff regime but would emerge unscathed.

CNQ’s latest big move was to buy Chevron’s (CVX) 20% interest in the Athabasca Oil Sands Project, bringing CNQ’s working interest in the project to 90%. The deal also included Chevron’s 70% interest in Duvernay acreage.

Chevron was motivated to make the deal to simplify its operations and help it fund its purchase of Hess Corp. (HES). It was also following the herd of major oil companies, as BP (BP), Shell (SHEL), ConocoPhillips (COP), Equinor (EQIX), and Devon Energy (DVN), have all sold their oil sands assets at what turned out to be discounted valuations to Canadian operators who have benefitted tremendously from owning and operating the assets.

In January, CNQ swapped its 10% interest in the Scotford synthetic oil upgrader and certain carbon capture facilities for Shell’s (SHEL) 10% interest in the Athabasca Oil Sands Project. This increased CNQ’s working interest in the project to 100% and added 31,000 bbl/d of synthetic crude oil production at a low cost. CNQ will still operate and own an 80% interest in the Scotford upgrader. We wouldn’t be surprised to see CNQ make additional deals to increase its stake in the upgrader.

This is another example of CNQ’s savvy moves to add high-quality oil production on the cheap.

In October, CNQ also increased its quarterly dividend by 7% to $0.5625. At its current stock price of $43.34, CNQ pays a safe 4.8% yield.

Tariffs that temporarily push CNQ shares lower would present a no-brainer buying opportunity. For investors concerned about the economic or oil price outlook on a longer-term basis, CNQ is an excellent ballast position in an energy stock portfolio. If an oil market or macroeconomic downturn were to arrive, CNQ could be sold to buy stocks trading at steep discounts with big upside in a recovery.

My top high-quality natural gas pick would be Tourmaline Oil (TOU:CA). Despite its “oily” name, Tourmaline is the CNQ of North American natural gas. Surprisingly, its shares have not significantly benefited from the speculative frenzy surrounding data center natural gas demand, which has pushed many of its peers’ stocks higher. TOU shares would be pulled down with the rest of the Canadian oil and gas sector, creating an attractive entry point for the stock.

TOU benefits from its world-class asset base and marketing operation. Its size and operational prowess allow it to capture higher natural gas prices available at the US Gulf Coast. The company is led by Mike Rose, one of the best executives in North American business. Rose has seemingly miraculously created a company in which the top talent in the industry feels at home, cementing a long-term competitive advantage that peers can’t touch.

Like CNQ, TOU has a multi-decade drilling inventory and high-returning assets. We expect the company to continue consolidating the most strategic natural gas producing properties in the western region of the WCSB. It will continue to do so on attractive terms for its shareholders, building value over time and increasing free cash flow, which will be distributed as dividends. TOU is an outstanding income play, and we own it in our HFIR energy income portfolio.

TOU is a big dividend payer. Consider that it paid out a total of $3.32 in base and special dividends in 2024 despite operating in one of the lowest natural gas pricing environments in history. TOU’s dividends in 2024 represent a 5.0% yield on its current share price of $66.81. Its dividends will be significantly larger if natural gas prices increase, as we expect.

On the income side, my favorite high-quality name is TC Energy (TRP). The company owns a massive natural gas midstream infrastructure footprint that is dominant in Canada, as shown below.

We’ve owned TC Energy shares in our HFIR Energy Income Portfolio since they sold off in late July 2023. We intend to hold onto the shares for many years.

TC Energy will benefit from the nascent LNG buildout and the growth of data centers. Large capital projects will grow its free cash flow for years, allowing the company to deliver and create additional value for shareholders. We prefer TC Energy shares over those of Enbridge due to the ladders, lack of exposure to natural gas supply, and demand growth in North America. TC Energy offers a safe 5.1% dividend yield on its current stock price of $65.66, which is likely to grow as its free cash flow increases over the coming years.

Tariffs mean trade war
As an outsider (neither American nor Canadian, neither democrat nor republican), I think that Trump is bonkers when he states that “tariff” is a beautiful word. Tariffs start trade wars. As any decent macro-economist will tell you, trade wars have no winners, only losers. The Smoot-Hawley act under president Hoover, imposing tariffs on Europe in 1930, started a trade war and contributed to the great depression.

Trade wars mean a loss of GDP and an increase in inflation for everybody. That is what no one wants

Impact of 25% Canadian tariffs
The 25% tariffs to be applied on Canadian imports serve no economic purpose. The US in 2024 had a $ 61 B trade balance deficit with Canada ($ 413 B imports and $ 352 B exports). However, if the $ 80-85 B of the oil and gas trades is excluded, then the US had a $ 20-25 B. trade surplus with Canada on manufactured goods.

Imposed tariffs will hardly affect the oil and gas trades. US refineries need the Canadia heavy oil and have no alternative supply. The Canadian gas is so cheap that even with a 25% tariff the volume of US imports will not change.

Imposed tariffs however will affect the manufactures goods trade. If Canada responds with tariffs on imports from the US, then this will lead to reduced activity and higher prices at either side of the border, A drop of 2-3% in GDP is floated for Canada.
In the US, being the bigger economy, the GDP reduction percentage will be less, but in absolute numbers the impact will be higher as the impact on manufactured goods on the US side will be higher.

Both the US and Canada will be losers after tariffs are implemented. Let us hope that American politicians come soon to their senses and that tariffs will disappear quickly.

Impact of tariffs on the Canadian oil and gas industry
The impact of tariffs will be different for Canadian oil producers and Canadian gas producers.

Canadian heavy oil and US refineries need each other, neither having any alternative. This makes price negotiations difficult on who absorbs the impact of the tariffs. I imagine that either side will have to make some concessions when negotiating future sales prices. This may result in 50% of the impact being born by Canadian suppliers and 50% by US refiners and the US public at large, although percentages can be different after negotiations.

The margins of Canadian oil producers are narrow. Canadian oil producers face 1) high royalties (15-18%) 2) high taxes (18-23%) and 3) medium/high unit costs ($ 28-38/bbl). Any reduction in realized oil prices will have a big impact on their profitability and thus on their share price.

Canadian gas producers should see a lower impact than the oil producers. For starters the percentage of the gas exported to the US (40%) is lower than that for oil (65%). Thus, the realized gas price is less dependent on US export prices.NGL prices will not be affected as there is no net export to the US,
Further, gas profit margins are higher as royalties on gas are lower (8-10%) and unit costs are relatively low ($ 1.90-2.50/MM Btu). As such gas producers will stay longer profitable than their oil producing counterparts.

What to do with Canadian oil and gas shares after tariffs are imposed.
Canadian oil and gas shares in general are more attractive than their US counterparts. Canadian companies in general have more reserves, higher production growth, better balance sheets, lower PE’s, and higher shareholder returns.

Tariffs will increase the PE and reduce the shareholder returns, but Canadian companies will remain attractive.

Currently there are 17 Canadian oil and gas companies and 8 US oil and gas companies in my top 25. With a 10% reduction of realized oil and gas prices for Canadian companies, this changes to 14 Canadian and 11 US companies, with mainly Canadian oil producers dropping out.

If you believe tariffs are temporary, then it is wise just to hold on to your shares. If you believe tariffs will be around longer, than I would reduce my holding in Canadian oil producers,

Let us hope that tariffs are short lived.

Good news: All the Canadian government needs to do is agree to tighten up the border security to stop drug traffic. Illegals coming into the U.S. from Canada is probably near zero today since Trump started deporting illegals.

Trump does sound crazy from time-to-time, but he is not an idiot. His team knows that we need the Canadian heavy oil. My take is that if he does impose the tariffs they won't last long. This is just his negotiating strategy.

Mexico is a much different situation.