Are energy stocks too cheap?

While the energy sector faces plenty of economic challenges, the challenge for investors is knowing whether valuations and current stock price levels in the sector accurately reflect the macroeconomic backdrop and thus support a buying decision.

“Is the equity market over- or under-reacting, or does it have it right?” asks a report on energy published on Monday by Toronto-based Richardson GMP. “That is where potential investment opportunities or pitfalls [lie].”

West Texas Intermediate crude has been rangebound in recent months, sitting around $60. While that price is profitable for North American energy producers, “the massive disconnect” between the physical market and equity prices is intriguing, the report said.

For example, the Canadian Exploration and Production (E&P) index has dropped 50% in the last three years.

“As a general rule, share prices don’t get cut in half unless there is lots of bad news,” the report said, citing such things as pipeline constraints and increased regulation in the oil sector.

With Canadian E&P stocks trading at an enterprise multiple of 4.8x (U.S. E&Ps are trading a little higher, at 5.6x), should investors buy?

With a lot of moving parts, “energy is either a value trap or potentially one of the great opportunities for the year ahead,” Richardson GMP said in the report. “We continue to wrestle with this question, but, as a general rule, the lower the price and valuation, the less risk there should be.”

The firm expects that current slower global growth will likely turn out to be another soft patch in a long, aging cycle. If its forecast holds, the energy sector would benefit.

In a monthly equities report for November, Montreal-based National Bank noted that a continued expansion is important for equity markets because the mature phase of an economic cycle tends to deliver double-digit returns — an average of 23.5% annualized for the oil and gas sector of the S&P 500.

Yet, though oil and gas tends to outperform other sectors in the mature phase, the sector is down so far in the last 24 months, and the resource-heavy S&P/TSX is still underperforming the S&P 500. National Bank attributes the lag in oil and gas to U.S.-dollar strength and the U.S.-China trade war.

If, on the other hand, slower global growth extends to a recession, the Richardson GMP report noted that oil prices and energy share prices would subsequently suffer, even if valuations are currently very low.

The outcome for the energy sector could also alter based on whether decline rates from shale continue to accelerate, whether OPEC extends production cuts and whether Canada can build a new pipeline, the report said.

“Time will tell how this one plays out,” it concluded.

For full details, read the reports from Richardson GMP and National Bank.