Canada’s Gusher: Winners From a New Oil Pipeline

Canada has the third-greatest oil reserves in the world, after Venezuela and Saudi Arabia. But it hasn’t been able to capitalize on all those underground riches because there haven’t been enough pipelines to get it to the markets where customers would pay up. Instead, Canada has had to sell much of its oil at a discount to U.S. refiners—a cross-border embarrassment nearly as damning as Canada’s 30-year Stanley Cup drought.

That’s changing now, to the benefit of several Canadian energy companies. The Trans Mountain Pipeline, a government-owned project that runs for 715 miles from oil-rich Alberta to Vancouver, just started operations this month after seven years of waiting. A much smaller pipeline had been serving that route for decades, but the new infrastructure will triple capacity, allowing producers to ship an additional 590,000 barrels of oil per day to customers.

Canadian producers will be able to ship their oil to Asia, or by barge to customers on the West Coast of the U.S. Previously, they were forced to sell much of their oil at a discount to Midwestern or Gulf Coast refineries, which reaped the lion’s share of the benefits when they sold products like gasoline at higher market prices.

The best way to see the importance of the Trans Mountain Pipeline is to look at the spread between U.S. and Canadian oil prices. Western Canadian Select has historically traded at a substantial discount to West Texas Intermediate—often over $20 per barrel. Today, that spread has shrunk to $13, and some analysts think it will eventually slip into the single digits.

“To me, this seems like West Texas and the Permian Basin 10 to 12 years ago,” said Denton Cinquegrana, chief oil analyst at OPIS. The Permian Basin of West Texas and New Mexico is the center of shale-drilling in the U.S., pumping out more than six million barrels of oil per day. A decade ago, the Permian’s growth was similarly constrained by a lack of pipelines. “They didn’t have a production problem, they had a takeaway problem,” he said.

Canada’s tar sands area, the section of Alberta known for its heavy, viscous oil, isn’t expected to become as productive as the Permian. And the industry has sludgy environmental problems it will need to remediate, perhaps with carbon capture technology. But several producers should still benefit as the pipeline network expands.

Among them are MEG Energy, Canadian Natural Resources, Strathcona Resources, and Cenovus Energy.

Canadian Natural Resources, the biggest and best-known of the bunch, trades at 12.8 times its expected earnings over the next four quarters, a higher valuation than most other Canadian oil-and-gas stocks. Some analysts see more value in names that haven’t gotten as much credit. Jefferies analyst Lloyd Byrne is particularly bullish on Cenovus.

Cenovus is mostly focused on oil production in Canada, but it also owns refineries in the U.S. that import oil from Canada. The refineries could be hurt as Canadian crude gets more expensive. Byrne, however, argues that Cenovus has significant upside, given that refining makes up just 20% of its operations and the company owns some of the best acreage for drilling in Canada.

“It has quality upstream resources and hasn’t been revalued,” he said. Shares trade at 9.6 times expected earnings. He thinks they can rise 27%.

Cole Smead, CEO of Smead Capital Management, also owns Cenovus, as well as Strathcona and MEG. He thinks that Canada will play an increasingly important role in the energy market as the new pipeline gives producers access to more markets. U.S. shale production is likely to decline later this decade as wells get tapped out, but Canada has years of potential growth ahead, Smead argues. “The Canadians have an advantage that once they’re producing, the assets are going to be producing for decades,” he said.

Write to Avi Salzman at [email protected]