Still Bullish? If Not, Look North to Integrated E&Ps

Where to turn for shelter during market uncertainty.

Nicholas Lupick, CFA

Despite recent weakness, which we anticipated with our July commodity update, our broader medium-term outlook for crude oil remains positive. With expectations for a modestly improving crude oil complex, we continue to believe that exposure to Upstream E&P entities such as Encana (ECA-N; OP; TP $17.00) and Canadian Natural (CNQ-T; OP; TP $60.00) are strong fundamental holdings (noting that the Canadian Integrateds have outperformed the E&Ps YTD by 12%). However, as the market remains uncertain around the outlook for locational discounts in Canada, taking shelter in some of the Canadian Integrated equities could prove profitable in the short term. We believe that the best-in-class entity for this purpose is Suncor (SU-T; SP; TP $61.00).

WCS Weakness: Feel Worse Before Feeling Better
WCS differentials have widened materially in recent weeks past the -USD 30/bbl mark as a result of oil sands production being placed back on stream after temporary shut-ins at a number of projects; the BP Whiting refinery (which consumes 250 mbbls/d of Canadian heavy — more than any other facility in North America) scheduling a seven-week turnaround in late August; and a slower-than-expected ramp up in crude-by-rail volumes. In our view, the differential is in its trough range with improvements likely to come in Q4/18.

Bearish? Look North to Integrated E&Ps
Skeptics of our bullish thesis for crude, who wish to remain invested in energy, should look to invest in refineries and integrated E&Ps for shelter. The refining and marketing operations of Canadian integrated E&Ps have achieved ~$5/bbl higher profitability on average per barrel of refining capacity compared to US refiners, making the group comparatively attractive (and still holding upside to the commodity through upstream growth project inventory).

The Punch Line
Overall, for investors looking to shield some of their exposure to Canadian crude oil differential volatility, we recommend an investment in Suncor. Husky (HSE-T; SP; TP $21.00), which has the best 1-for-1 alignment of its integration although the stock’s outperformance to date leaves little justification for additional weighting; Imperial’s (IMO-T; SP; TP $47.00) second-best rank by profitability is overshadowed by weak alignment of feedstock slates and poor (upstream) operational performance; and Cenovus (CVE-T; OP; TP $18.00; here), whose acquisition of Conoco Canada’s operations has left it largely exposed to upstream differentials.

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