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Four Energy Stocks on Sale

These Canadian stocks aren't trading on long-term prospects.

Kish Patel, 08/19/2008

Summer isn't just a time for vacations, ice cream, and blockbuster escapism. While others are taking a siesta, savvy investors should be on the lookout for opportunities to snap up quality stocks at appropriate margins of safety. A swift drop in oil and natural-gas prices coupled with nervous equity markets have battered several Canadian energy stocks to prices well below our estimates of their long-term fair value.

First, a review of the latest happenings in Canadian oil and natural gas. Capital cost inflation continues to plague projects in northern Alberta; most recently, Canadian Natural Resources CNQ announced another overrun at its Horizon oil sands project, and Petro-Canada PCZ had to increase the cost estimate for its Edmonton refinery conversion project. Industrywide operating costs have risen in tandem with rising commodity prices, and while the recent drilling downturn provided a brief reprieve on drilling and services costs, signs point to renewed pressure this coming winter. Another grievance for producers are the delays that have become routine around the world. Nexen's NXY Ettrick development and Talisman Energy's TLM Rev subsea tieback are only the latest examples of such frustrations. 

And yet these problems are largely a product of good fortune: robust commodity prices and the high levels of activity they encourage. Our current expectations for oil and natural-gas prices translate to high returns on invested capital for several Canadian energy companies. Further, while access to resources has been a fundamental challenge for international operators, new continental frontiers are being established as technology improves the economics of unconventional plays. (The mania over shale plays across North America has even brought its special fever to land sales in northeast British Columbia.) While commodity prices are inherently volatile and subject to sharp movements, at current equity prices, we feel the market is far too pessimistic about the long-term futures of the following stocks.

EnCana ECA
It's a difficult feat to find a major natural-gas play in North America where EnCana hasn't already established a dominant acreage position. From northeast British Columbia (home of the Montney tight gas and Horn River shale gas plays) to the prolific east Texas region (the Deep Bossier play), EnCana has an enviable opportunity set. What separates it from most of is peers is its patience with reservoir evaluation and its technical innovation. Add high-quality in-situ oil-sands assets that will get spun out to investors as part of a new integrated oil company, and EnCana has a great deal to recommend it.

Canadian Natural Resources CNQ
The disciplined capital allocators at Canadian Natural have built a resource base that offers topnotch economics, long-term scalability, and operational flexibility. While the Horizon project is at the forefront of the company's opportunities, don't overlook its massive heavy oil resources or its large natural-gas acreage position. Canadian Natural's international operations, which already generate free cash flow, should soon receive a production boost from redrilliing at Baobab and the startup of the Olowi development in offshore west Africa. With hedges falling off and the ramp-up of the first phase of Horizon, we expect 2009 to be a terrific year for Canadian Natural.
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Petro-Canada PCZ
Petro-Canada will soon make a final investment decision on its Fort Hills oil sands project, an undertaking which promises to be an immense challenge. However, this integrated Canadian energy company also has a number of other value-creating projects in the works, such as the aforementioned refinery conversion and its international expansions in Libya and Syria. Profitable legacy assets include North American natural gas and offshore oil production from the east coast of Canada and the North Sea. Although we expect the downstream business to continue to face near-term head winds from weak end-product demand, we feel the market is overlooking all the other opportunities available to the company.

Talisman Energy TLM
After a somewhat disappointing operating period during the last couple of years, we feel Talisman's new corporate strategy should help to focus the company. Its new push to develop unconventional natural gas and oil may be tricky, but we are optimistic Talisman is taking the right steps to unlock significant value from these assets. A growing business in Southeast Asia offers attractive economics and myriad development opportunities. Stable North Sea assets will help fund a robust global exploration program that has the potential to refill Talisman's opportunity bucket for many years to come. We think Talisman is poised to deliver on its tremendous potential.

Kish Patel is an analyst with Morningstar.

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