Energy stocks are a major component of the TSX index and many of the big players in the space have just reported their latest earnings. Michael O’Brien, Portfolio Manager, TD Asset Management, explains to MoneyTalk’s Greg Bonnell why some positives may lie ahead for the sector.
- Energy stocks are, of course, a major component of the TSX Index. And many of the big players in the space have just reported their latest earnings. Well, our featured guest today says it was a messy quarter, but there's also some positives. Joining us now with more, Michael O'Brien, portfolio manager at TD Asset Management. Michael, great to have you back on the show.
- Thanks, Greg.
- So we're in the thick of earnings season, at least on this side of the border. And we've had our big energy names so far. You're saying it was a bit messy. What did you see through it all?
- Well, the reality is that these companies are operating some pretty hostile environments when you think of northern Alberta in the winter. So the Q4 and Q1, you tend to have some operational hiccups, quite often weather-related. And so we saw that flowing through the numbers. The production numbers and the upstream business were kind of a little bit soft. And then you also had some issues with a number of the integrated players, like Cenovus and Suncor, with downtime in the refineries, Cenovus in particular. So it was just one of those quarters where things weren't clicking on all cylinders. That said, they were all still very profitable, generated a lot of cash, and a decent amount of that came back to shareholders in dividends or buybacks.
- You talk about still being profitable. That's interesting, obviously, of course, because the price of crude oil on average for the first quarter of last year, much higher than it was for the most recent quarter of this year, but still profitable at these levels.
- Oh yeah. And I think that's something, especially after the last five, six years, we went through a period where oil prices were quite weak for an extended period of time. We kind of forget that-- so in Q1, the quarter just passed, oil prices kind of bounced around between $70 and $80. That doesn't sound as exciting as last year, like you said, when it was over $100 a barrel.
But relative to where it was in the late part of the last decade, these are pretty robust prices. So we kind of forgotten that $70-$80 a barrel of oil for the Canadian producers, that's a very healthy level. So we've seen all of these companies continue to improve their balance sheets. They all continue to return cash to shareholders. If oil were to stay $70-$80, it doesn't sound as exciting, but that's a very, very attractive level for these producers.
- What can shareholders expect going forward? After a year-over-year comparison, you get past those tough winter months when you can have operational challenges, what does the rest of the year look like?
- Well, the rest of the year should be a bit smoother. Like, for example, Cenovus, which is one of the big Canadian players, they were kind of almost operating with one hand tied behind their back in Q1, where four of their five refineries were basically out of commission or running at suboptimal rates. Management tells us hopefully, by June or July, those should all be back up and running at 100%. You should see a nice improvement there. You think about the weather-related downtime we saw in Q4, Q1, that should be behind us now.
So I think the outlook for the back half of the year is pretty good. And so really, what investors are focusing on now is, as they rightly should have, these companies focused initially coming out of the pandemic in the recovery period about delevering the balance sheets. They use that free cash flow they were generating to get debt to a more sustainable level.
The exciting thing for equity holders now is that, by and large, all of these companies are within striking distance of that sort of magic number where they figure the debt levels have gotten where they're comfortable with. And beyond that point, basically all the free cash flow that gets generated is going to come back to us either as dividends, buybacks, special dividends. And so for example, CNQ, Canadian Natural Resources, their magic number is $10 billion of net debt.
They're a couple billion dollars off. They figure by late this year, or early next year, they'll reach that $10 billion plateau. Going forward after that, 100% of the free cash flow they generate will come back to shareholders.
Cenovus, their magic number is $4 billion in net debt. They're at about 6.5 billion today. They figure by the end of this year they'll be there. So that's the thing that I think investors should keep their eye on is, barring something really unforeseen in terms of a major, major decline in the oil prices, the free cash flow being returned to shareholders by these big players should continue to accelerate as we go into 2024.
- I was going to ask you how much does an investor who's taking a look at the Canadian energy patch have to worry about those external sort of factors, whether it's a global economic slowdown that depresses demand, or even what OPEC gets up to well?
- Absolutely. Oil is a global commodity. The world runs on oil. And as we've all seen, whether fundamentally justified or not, oil prices will swing quite violently with the macro mood of the day. So if what you're reading about when you get up in the morning is recession, if you see the r-word as a headline in the business section, chances are oil prices are going to respond to that negatively.
On the other hand, if people get more optimistic about the economic backdrop, or focus on things like China reopening, that tends to put a bid under oil. Those are macro, top-down driven, or sentiment-driven drivers, but they're very real for oil. But at the end of the day, what it comes down to is the supply and demand fundamentals. And that washes out in inventory trends.
And so really, we try to look through the noise. We understand that headlines will buffet the oil price. Like I said, it's been bouncing around between $70 and $80 year-to-date. But at the end of the day, if we keep our eyes on the real fundamentals in terms of supply, outstripping, demand, are inventories drawing or building, that's really going to tell us where oil prices are going to be 10, 12, 24, 36 months from now.
- Right. I think about the Canadian market. Obviously, energy is a huge part of it. The financials, they haven't reported. They come at the tail end. But we have heard from some of the miners. I mean, you've got gold above $2,000 an ounce. What's the picture there?
- Well, obviously, you know, what's been taken away from oil in terms of the negative sentiment around the economy, and obviously, gold tends to feed off of liquidity, it tends to feed off of macro fears as well. So where you see people quite concerned about the US regional banks, you hear talk of a banking crisis, those are the types of things that put a bid into gold. And they're the same things that have been kind of undermining oil and some of the other commodities year-to-date. So gold has been sort of the beneficiary of the difficulties that some of these other commodities have been weathering.
North of $2,000, obviously, that's a very attractive gold price for the miners. Where they're struggling a little bit, though, is on not so much on the revenue side. It's on the cost side, and just maintaining efficient operations. A lot of input cost, inflation, a lot of the things you need to run a mine have gone up a lot in price over the last little while. And so even though the headline "Gold Bullion Above 2,000," you would think that would be free cash flow gushing out of these companies, they're kind of getting a lot of pressure on the cost side that the free cash flow follow-through isn't as great as you might expect.