February 8, 2010
Exploration & Production
Go North: Canadian E&Ps
Oily & Cheap; Upgrade CNQ
We see opportunity based on a widening value
disconnect between US and Canadian E&Ps: The
Canadian E&Ps under coverage are trading at
discounted valuations seldom seen over the last 5+
years relative to both the forward curve and their US
peers. As a group, they offer a lower-risk,
longer-duration play on commodity prices, in our view.
We would use recent underperformance to build / add to
positions in the higher-quality Canadian large-caps. We
reiterate our Overweight rating at SU and upgrade CNQ
to Overweight from Equal-weight.
What’s driving the valuation disconnect?: Canadian
E&Ps screen cheap based on both multiples of forward
cash flow and asset values at the forward curve. We
think a number of factors are at play:
1) Increased risk aversion to crude, as the equity /
forward curve discount has widened since YE2009.
2) The Canadian names are resource rich, but often
perceived as catalyst poor. Absent expectations for
rising commodity prices, investors have focused on
exploration & drilling catalysts for 2010, this leaves the
Canadian large-caps out of favor.
3) Broadly speaking, many Canadian producers have
come off significant capex cycles in 2008/09 and are set
to deliver production growth / cash flow in 2010/11 as a
result. This has driven multiple compression, and we
look to own names into rising expectations for the next
phase of growth.
Upgrading CNQ to Overweight: The stock trades at a
2010 free cash flow yield of ~7.3% at the forward curve.
Ramping volumes from phase I of the Horizon oil sands
project (110 mbpd) drives 7% volume growth in 2010,
while sanction of phase II/III (130 mbpd) should drive
longer-term growth expectations higher. A deep heavy
oil resource base levers CNQ to two key trends in
energy today: higher long-term crude prices, and narrow
light / heavy differentials. We see 30% upside