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Patrick J. O'Rourke, CFA

Key themes and investment trends for 2023.

As investors begin to navigate the complexities of investing in Canadian upstream oil and gas in 2023, we are releasing our updated commodity assumptions and equity outlook/key themes and investment trends for 2023 and beyond. In summary, we expect continued strong medium and long term investment appeal for the Canadian upstream and integrated oil and gas sector, with markets navigating volatility and the impacts of macroeconomic and recessionary challenges in the near-term. These near-term challenges see our 2023 forecasts for industry profit margins and returns on capital modestly lower than 2022, but still well above the long-term industry averages. In our view, with lower financial leverage now embedded across the sector and a slowing in the velocity of actionable return of capital step changes, in 2023 investors should focus on those producers with the highest quality operations and upstream inventory depth to drive risk-adjusted investment outperformance.

Key 2023 Themes:

Potential for Continued Near Term Equity Volatility Driven by Pressure for Negative Earnings Estimate Revisions
Since the start of Q4/22, both the oil and gas forward strip pricing has experienced persistent downward pressure, both now sit well below current consensus expectations in published estimates across the street with the current gas 12 month strip price now sitting 10.0% below consensus, and oil 12 month strip 11.9% below.This gap between street expectations and current strip pricing is likely to contribute to a near-term negative earnings revision cycle that increases up oil and gas equity volatility.

Strong (but Volatile) Crack Spreads will Impact 2023 Integrated Cash Flows 
Over the course of 2022 strong crack spreads have benefited integrated producers. The benchmark mid-continent 3-2-1 crack spread averaged US$24.63/bbl in 2022 relative to US$17.35/bbl in 2021. However, crack spreads have also been highly volatile, reaching a high of US$58.02/bbl and low of US$12.88 in 2022. Strong (but volatile) crack spreads were a driver of strong cash flows for integrated producers in 2022 and will continue to be a key drivers of cash flow and earnings revisions for investors in our three integrated producers (Cenovus, Imperial Oil, and Suncor) in 2023.

Long Anticipated Structural Improvement to Canadian Upstream Outlook takes hold in 2H/23 
Recent commentary from the operators of the Coastal Gas Link (CGL) and the Trans Mountain Expansion (TMX) indicates the potential to see the projects mechanically complete by Q4/23. While investors generally take a ‘don’t count your chickens until they hatch’ approach to Canadian oil and gas egress expansions (rightfully so), 2023 has the potential to bring to fruition long anticipated step changes in Canadian oil and gas egress capacity and industry growth potential with both key pipelines set to change the competitive dynamics of Canadian price realizations by adding material access to waterborne PADD 5 and Asian markets.

Asset Quality and Operational Performance will be in Focus and Differentiate Equity Performance
Since 2018 company average valuations have been effectively cut in half. Moreover, through this timeframe in which investors have observed clear multiple compression, a significant convergence in valuation spreads between the most expensive to least expensive stocks has simultaneously occurred. Lower inherent financial leverage in the sector (balance sheets largely repaired) and the velocity of step changes in codified return of capital actions slowing, we believe that a key driver of large and mid cap equity outperformance in 2023 will ultimately be operational performance at the field level and the ability of management teams to effectively convey differentiated asset quality. To that end, we see companies such as ARC, Tamarack Valley, and Tourmaline with consistently strong operational performance profiles, while the likes of Kelt and Paramount with underappreciated resource bases and asset value are well positioned for outperformance relative to their peer groups in 2023.





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