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Energy stocks have rallied hard of late but a distorted North American oil market means that investors need to pay close attention to valuation levels to protect themselves from a potential sell-off.

Is there any value left in the oil patch? A close look at the numbers suggests that at current prices, the sector includes both pockets of opportunities and a few potential portfolio land mines.

The danger for oil prices comes from the inexplicable shape of the West Texas Intermediate futures curve. For more than a year, oil producers have been committing to sell crude in the future at far lower prices than they could get in the open market. As an example, producers are currently selling oil for delivery in September 2016 at $85.00 (U.S.) a barrel – almost $20 lower than the spot price of $104.06.

For investors, the important implication is that when this backwardation pattern in the futures market has happened previously, oil companies have stopped selling in forward markets and unleashed inventory at the higher spot price. The result is sharply lower oil prices.

Market history dictates that if crude prices fall, expensive stocks will move most, and not in a direction investors will enjoy. This means that attractive valuations are the main method for investors in energy stocks to mitigate the potential damage.

The S&P/TSX Energy Index is definitely expensive relative to its three-year history, based on both cash flow and earnings. The current trailing price to earnings ratio is 29.8 times, well above the three year average of 22.1 times. Aggregate price to cash flow valuations tell a similar story. Stock prices now reflect a sector trading at 8.1 times trailing cash flow when 7.2 times has been the average.

There are 33 stocks in the benchmark with a three-year history of positive earnings that allows for PE comparisons. Of these, only seven are trading at significant valuation discounts.

There are 51 stocks in the S&P/TSX Energy Index with three years of positive cash flow. More than three-quarters of these stocks are trading well above their three-year averages in terms of price to cash flow.

There are a number of companies trading at valuation levels 50 per cent and more above their historical averages. These include Calfrac Well Services Ltd., Nuvista Energy Ltd and Paramount Resources Ltd.

Overall, the domestic energy sector is richly valued, but not insanely so. Crude prices remain high, thanks to geopolitical tensions and hopes for a strengthening U.S. economy, and profits from the oil patch will reflect this.

Still, it doesn't make much sense for oil producers to sell forward crude at prices so far below the spot price. If or when inventory selling at spot prices starts in earnest, a torrent is likely to become a flood in a hurry as producers look to take advantage before prices normalize.

The sell-off may never happen, but investors in the domestic energy need to manage risk and keep their stock valuations as low as possible in case it does.

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