Skip to Content
Stock Strategist

Canadian Energy Picks from the Rubble

Long-term investors should take a close look at these stocks.

Mentioned: , , , ,

Much like the rest of the world, the Canadian stock market is facing serious turbulence. The broad S&P/TSX Composite index has been battered by concerns over the banks' subprime exposure, asset-backed commercial paper, and falling commodity prices. The energy sub-index has fallen by 9% since the end of July. While market uncertainty might persist over the short term, we think the recent spate of selling has unearthed some solid energy opportunities for long-term investors.

A Declaration for Independents
The emergence of Canadian energy trusts in recent years has left behind only a handful of large senior independent exploration and production companies. We think that all four of the following Canadian producers have a host of rich opportunities, each with its own unique strategy. All are trading near or below an appropriate margin of safety to our fair value estimates.

 Canadian Natural Resources (CNQ)
Morningstar Rating: 4 Stars
Business Risk: Average
Economic Moat: Narrow
Canadian Natural has built itself on smart capital allocation. The company won't chase the hottest plays, but instead seeks out the best returns. For example, its heavy oil plays might not be flashy, but they offer outstanding economics, and this is one reason that the company was able to drastically reduce 2007 natural-gas spending in response to inflated Canadian service costs. With the first phase of its Horizon oil sands project is scheduled to begin midway through 2008, the company will generate large amounts of free cash flow that will help fund subsequent phases of growth. Canadian Natural is the most levered of these independents, but we don't anticipate the company having difficulty meeting its obligations or funding future capital expenditures.

 EnCana  (ECA)
Morningstar Rating: 4 Stars
Business Risk: Average
Economic Moat: Narrow
EnCana has reconstituted itself in recent years to focus on natural-gas opportunities in North America. The company has done a solid job of keeping down costs for both operating production and finding new reserves. Like Canadian Natural, the company cut back its capital spending in 2007 in response to high service costs. Now that service costs in western Canada are moderating, we expect EnCana to ramp up drilling and production growth in the coming years. EnCana's unconventional resource plays could offer significant upside reserve potential if they can be unlocked by new technology or drilling techniques. The company's oil-sands partnership with  ConocoPhilips (COP) also allows for integrated exposure to the oil sands over the next several years.

 Nexen (NXY)
Morningstar Rating: 5 Stars
Business Risk: Average
Economic Moat: Narrow
Although it's somewhat smaller than the other three senior independents, Nexen is no lightweight. Nexen is the oiliest of the bunch, with key crude areas in the North Sea, Yemen, the Gulf of Mexico, and Canada. The Buzzard field in the U.K. has been the driver of production growth in 2007. Buzzard offers high cash-flow netbacks because of its quality light oil and low operating costs, though it is subject to a higher U.K. tax burden. Buzzard will be followed in 2008 by first oil from the Ettrick field and the ramping up of the Long Lake oil sands project in western Canada. Nexen has a 50% interest in Long Lake, a project that will use gasification to help keep down the oil sands' notoriously high operating costs.

 Talisman Energy (TLM)
Morningstar Rating: 5 Stars
Business Risk: Average
Economic Moat: Narrow
Asset dispositions, lowered guidance, and a change in leadership have clouded the short-term picture for Talisman, but we still think the company will deliver on its potential over the long term. While the other seniors each have an element of unconventional resources in their portfolio, Talisman is focused strictly on conventional oil and natural gas. Its crude oil portfolio spans the globe, with opportunities in the North Sea, Southeast Asia, and North Africa, and natural-gas opportunities throughout western Canada. Incoming CEO John Manzoni will need to shepherd current projects through to fruition, and if he uses the expertise of the veteran team around him and sticks to Talisman's conventional strategy, we think Talisman will be well-positioned for the long term.

How Current Issues Will Affect the Independents
A revaluing of risk could mean higher borrowing costs for the independents, but we don't expect that to be a major issue for these four companies going forward. Another near-term issue is the natural-gas storage situation in the U.S., which has recently depressed natural-gas prices and could continue to do so in the near-term. However, as demonstrated by western Canadian drilling activity, natural gas drilling and production can swiftly come to a halt. Over the long term, we expect the stranded nature of natural gas to support prices, and we expect OPEC to do the same for oil prices. The turbulence might not yet be at an end, but we think these well-run Canadian energy companies are starting to trade at attractive levels relative to what they're worth.

Kish Patel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.