From Canaccord daily mail:
Oil Prices Sensitivities - Another bull market in the making REVIEW
We are raising our estimates of 1999 and 2000 earnings and cash flow
for oil and gas producers as a result of rising commodity prices. In
this environment, earnings and cash flow grow, and market multiples
tend to expand. The TSE Oil and Gas Producers Index is already up 50%
since the beginning of March, but we believe that there is an
opportunity for additional capital gains, particularly among medium
and small sized producers.
If we assume that West Texas Intermediate crude oil prices average
US$18.00/bbl for the balance of the year, the 1999 average will be
closer to US$16.50/bbl than our original US$15.25/bbl assumption.
Also, if the Henry Hub price of natural gas continues to rise through
the summer and fall months, an average of US$2.20/mcf is entirely
possible, and that would result in an unprecedented Canadian spot
price of $2.85/mcf. In fact, producers are now able to sell their
uncontracted natural gas forward at prices well in excess of
3.00/mcf, thanks to low North American gas directed drilling and steep
gas decline rates.
Table 1: Commodity Pricing Assumptions, Production, and Results
(table not available in email version)
Table 2 shows the impact of higher oil and gas prices on a typical
Canadian producer. The cash flow generated for each barrel of oil
produced has more than doubled over the past three months. Canadian
natural gas prices have also increased dramatically because of new
export pipeline capacity and a narrower differential between US and
Canadian prices. Moreover, after two years of lower capital spending,
the cost of land and oilfield services has adjusted downward,
facilitating a possible decline in finding costs in 1999.
Consequently we expect the margins or 'recycle ratios' to improved
dramatically throughout 1999.
We have calculated revised cash flow estimates for 40 producers that
we actively follow, using our new oil and gas price assumptions.
Based on these estimates, senior producers are now trading at an
average 5.0X 1999 cash flow, intermediate producers at 4.8X, and
junior producers at only 3.8X. Clearly, there is still room for the
juniors to catch up, but the question is; "Is there still room for
senior and intermediate producers stocks to appreciate?"
Table 2: Oil and Gas Production Economics
(table not available in email version)
In a normal market, stocks trade at about 6X forecast cash flow,
depending on a number of factors such as balance sheet, liquidity, etc.
In bull markets like 1993 and 1997, multiples tended to increase to
eight and nine times cash flow, and juniors have even traded at
premiums to seniors. In Table 3 we have calculated some theoretical
target prices for the 40 stocks based on 6X cash flow and 8X cash flow.
This is not meant to suggest that stocks like Summit are about to
triple in value because they are small companies and often fairly
illiquid. It is meant to show relative values and the potential for
further capital appreciation. These columns show that even the senior
producers do not yet appear to be fully discounting $18.00/bbl oil,
and there is still excellent value in medium sized and small producers.
The unusual confluence of rising oil and natural gas prices creates
the potential for another bull market in the oil and gas sector.
Chart 1 shows combined oil and gas prices (benchmark Canadian crude
and Alberta spot gas), converting natural gas to oil on the basis of
10M cubic feet to one barrel. Although oil prices continue to be at
historically low levels, natural gas prices are very bouyant, and on a
combined basis, prices are now almost as good as they were at the peak
in 1997.
Chart 2 shows the close relationship between oil prices and stock
price performance. The end of the "gas bubble" drove the bull market
of 1993, while the 1997 bull market was driven by US$25/bbl oil prices.
While we do not see a return to US$25/bbl oil in the near future, we
do anticipate record natural gas prices that could fuel another very
strong market for oil and gas stocks.
Chart 1: Combined Oil and Gas Prices (1 bbl : 10 mmcf)
Chart 2: TSE Oil and Gas Producers Index
(charts not available in email version)
There are some risks in this recovery however. One of them is the
Canadian dollar, which has rallied as commodity prices - including
crude oil - have regained momentum. Each one cent move in the value
of the Canadian dollar affects Canadian benchmark crude prices by
about $0.39/bbl. Another risk is the potential for a rapid resumption
of drilling activity worldwide, which would ultimately begin to
negatively affect prices. We anticipate that the heavy oil
differential will widen as producers resume production of the lower
quality crude. These items, however, are small against the backdrop
of much improved oil and gas supply and demand fundamentals.
Table 4: Benchmark Canadian Crude Oil Prices
(table not available in email version)
We continue to recommend that investors maintain an overweight
position in oil and gas producer stocks, in anticipation that this
sector will continue to outperform the broader market.
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