Skip to main content

The Globe and Mail

How mergers and acquisitions could crimp Canadian energy share prices

Globe and Mail columnist David Berman.

The Globe and Mail

Investors betting on Canadian energy stocks have more to worry about than the price of crude oil: The oil patch is saturated with new shares, thanks to surging deal activity, at a time when stock prices are hardly cheap.

According to Ian de Verteuil, head of portfolio strategy, quantitative and technical analysis at CIBC World Markets, this combination "means there could be high downside risk in these stocks if oil prices weaken."

The price of crude oil is currently sitting at about $50 (U.S.) a barrel. While that's up considerably from a low of about $26 a barrel early last year, the price is less than half of what it was three years ago amid concerns about a supply glut.

Story continues below advertisement

Canadian energy stocks have been on a similar ride. The sector collapsed by more than 50 per cent between 2014 and 2016.

Though the sector has since rebounded about 39 per cent, the recovery has lost momentum this year and share prices remain 32 per cent below their 2014 levels.

For some contrarian investors, the beaten-up look of Canadian energy stocks looks like a rare bargain opportunity when many observers are concerned about stretched North American equity valuations.

But in a note, Mr. de Verteuil offers a compelling look at why the bullish case for energy stocks really needs the price of crude oil to play along.

His first concern taps into the brisk pace of mergers and acquisitions activity in the oil patch, as Canadian companies buy assets from departing foreign-based energy producers, funding the deals in some cases with a flood of new shares.

For example, Cenovus Energy Inc. recently issued $3-billion (Canadian) in new shares to help fund its $17.7-billion deal for assets from ConocoPhillips Co. In a related case, reports suggest that Royal Dutch Shell PLC has decided to sell its $4-billion stake in Canadian Natural Resources Ltd., marking what could be one of the biggest equity sales in Canadian history.

According to Mr. de Verteuil, the value of stock issued by energy companies has recently risen to more than double normal levels, at a time when the appetite for Canadian energy shares among Canadian and foreign investors is unclear.

Story continues below advertisement

"We believe that uncertainties regarding NAFTA, and a less bullish perspective on Canadian oil sands have generally made foreigners cautious on Canadian equities," especially with a looming equity offering from Saudi Aramco, Mr. de Verteuil said.

"In addition, the past few years has actually seen Canadian investors limit [and occasionally shrink] their commitment to Canadian equities," he added.

One reason investors have limited their exposure to Canadian stocks is because the S&P/TSX composite index has a heavy concentration of financials and energy stocks, discouraging portfolio managers from overweighting these heavyweighted areas.

For example, the energy sector accounted for 18.5 per cent of the benchmark index in December, 2015, when mutual funds were underweight the sector by 200 basis points (or two percentage points). By December, 2016, the sector's weighting had increased to 21.4 per cent, and the mutual fund underweighting had risen to 320 basis points.

New issuance isn't going to help the situation, especially when the shares are hardly a steal.

Mr. de Verteuil's argument that energy stocks aren't cheap may come as a surprise given how far energy stocks have fallen over the past few years.

Story continues below advertisement

He values integrated energy producers and exploration and production (E&P) companies using enterprise value to debt-adjusted cash flow, a common metric for the oil and gas sector that takes debt levels into account.

The bad news? Valuations are merely in line with long-term averages – even after falling sharply over the past year. If the stocks aren't cheap amid new share issuance, they are perhaps more sensitive to falling oil prices than rising oil prices.

"At the end of the day, energy stocks are highly sensitive to energy prices – and a big rally in the price of [crude oil] will positively impact the stocks regardless of supply," Mr. de Verteuil said.

"The reality, however, is that when valuations are above average, the risks are asymmetric – a drop in oil prices is likely to be more impactful on equity prices than a move in the other direction."

Som Seif, CEO of Purpose Investments, gives advice for investors at a time when NAFTA , and potential changes to it, are on everyone's mind
Report an error Editorial code of conduct
Tickers mentioned in this story
Unchecking box will stop auto data updates
Comments

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff.

We aim to create a safe and valuable space for discussion and debate. That means:

  • Treat others as you wish to be treated
  • Criticize ideas, not people
  • Stay on topic
  • Avoid the use of toxic and offensive language
  • Flag bad behaviour

Comments that violate our community guidelines will be removed.

If your comment doesn't appear immediately it has been sent to a member of our moderation team for review

Read our community guidelines here

Discussion loading…

Due to technical reasons, we have temporarily removed commenting from our articles. We hope to have this fixed soon. Thank you for your patience. If you are looking to give feedback on our new site, please send it along to feedback@globeandmail.com. If you want to write a letter to the editor, please forward to letters@globeandmail.com.