Bull Energy Market Has Room to Run

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Daniel Greenspan, director, equity research, CIBC Asset Management. 

In terms of where we are in the energy bull market, our view is that we’re probably in the middle innings of the current cycle. So, the current bull market has lasted around 45 months, and over the last 60 years, there’ve been four other energy bull markets that have lasted on average of 92 months with the longest being over 112 months, and the shortest being 67. 

Since this bull market started in April 2020, the Canadian energy sector has experienced a cumulative return of 140% compared to the broader S&P/TSX composite, which has returned 76%. So, we would consider that this cycle started in early 2020. And ignoring the move into negative prices in April of that year during the highly uncertain early days of Covid, oil bounced from around $20 a barrel in May of 2020 to a peak of $120 per barrel in early 2022 when Russia invaded Ukraine and there was significant uncertainty around Russian energy sanctions and Russia weaponizing energy exports. 

That turned out to be a bit of a false peak, and the market calmed down and took stock of the supply and demand fundamentals, and the oil price really settled into a very healthy $70 to $80 a barrel range with a few moves above that range.  

Most recently, the oil price has pushed out of that $70 to $80 a barrel range, again, to the upside with the market pricing in geopolitical risks in the Middle East. And should the war in Gaza turn into a wider regional conflict, there could be material risks to the supply side for oil. So that’s some context for where we are right now. We do think we may be a bit outside of a fundamental price range with political risk adding a bit of a premium to the oil price, but we do think the political risk premium is justified at the moment given the ongoing risks in the Middle East and in Ukraine and Russia. 

So, in terms of what’s driving the bull market from the supply and demand side, we do think that the current oil price cycle has some legs. On the demand side, we’re likely getting into a rate-cutting cycle, and so the timing and the magnitude of the coming rate cuts are certainly up for debate and expectations are changing all the time. But directionally, we think rate cuts are coming and expect that to be stimulative and supportive for key economies like the U.S. that continue to support oil demand in the coming months and years. 

Also, on the demand side, the economic data out of China has been OK and is slowly improving. There’s been some puts and takes in different sectors. The country reported real GDP growth of 5.3% in the first quarter of 2024, which was better than consensus expectations. Industrial production growth was pretty strong. Manufacturing and infrastructure investment were also strong. The offsets were ongoing property sector weakness and weak retail sales. 

So, taken all together, the surprise to the upside this year has been on the demand side. We’ve seen demand expectations ratchet higher this year already from the IEA to 1.2 million barrels per day from its early forecast of 0.9 million barrels per day. Meanwhile, the supply side has been consistent. We’re seeing OPEC stick to the script and manage the supply side to balance the market. And closer to home in North America, growth from public companies has been very measured. 

In terms of how we see this evolving in the coming years, we do expect oil and energy demand to continue to grow as we get into an easing cycle with monetary policy. We aren’t expecting huge demand increases, but at the same time, we expect the supply side to remain disciplined, with swing producers trying to match supply with demand. 

Despite popular opinions suggesting imminent demand destruction for oil, there are many reasons to forecast continued demand growth over the medium term. Throughout the last 40 years, demand for oil has largely mirrored GDP and population growth, with both expected to continue their upward trajectory.  

Over the very long term, we do believe in the energy transition theme, and we do think the world will still work towards decarbonization, but we also think that that process to decarbonize is on a longer timeline than most people expect. The infrastructure build out to decarbonize is a huge undertaking on a scale that will require a massive investment in the electrical grid and the production of green energy. That investment is going to take time and money to turn into reality, and there are real limitations on how fast that transition can happen. 

And at the same time, we don’t expect the supply side for oil to continue investing in long-term growth to support a market that eventually will be in structural decline. So, we expect reduced investment in oil supply will precede falling demand, and we expect the market to remain tight in terms of supply and demand, even when demand is eventually peaking and rolling over. In other words, we don’t expect oil to go out with a whimper. 

With all that in mind, the companies have become more shareholder-friendly, and that’s a positive for investors. In recent years, energy companies have become significantly more shareholder-friendly, and that change in strategy is not totally altruistic. For a lot of reasons, that strategy was pushed onto the energy companies. Firstly, debt has become expensive again for the first time in a generation, so money isn’t free anymore, and these companies can’t just tap the debt market like they had in the past 15 years to fund growth. 

Second, equity markets are not as open to the energy companies as they once were. Investor ESG focus, shrinking pools of capital that are energy focused means that the equity markets for energy companies are not open in the same way that they were years ago, which limits capital available for growth. Investor expectations have also changed. It isn’t growth at all costs, but rather a focus on measured and sensible growth with shareholder returns and focus. 

Companies that don’t get it or deviate from that strategy get punished by equity investors who are voting with their feet and selling the stock.  

Finally, political uncertainty is also contributing to a change in focus for capital allocation. Permitting challenges and regulatory hurdles to investment in the next generation of energy assets makes it harder for companies to make long-term investment decisions, and as a result, cash is being returned to shareholders rather than being reinvested in growth. 

So, with that background in mind, energy companies are refocusing their priorities and the narrative shift. Step one was to fix the balance sheet and free cash flow after investing to maintain operations that was allocated to reduce debt. Most companies are targeting a level of net debt to EBITDA of one times, at a $50 oil price, effectively putting the balance sheet in a position where it’s protected even in a significantly lower oil price environment. 

Next, incremental free cash flow is going to dividends. And finally, cash flow remaining after that is being allocated to special dividends and buybacks. As net debt targets get hit, more capital is being allocated to shareholder returns. We think this theme of capital return in the energy sector continues to have legs from here, as companies are generating meaningful free cash flow at current oil prices.  

And the proof’s in the numbers, investment in growth has not recovered to anywhere near the peak levels we saw in the previous decade, while dividends and buybacks have hit peak levels not seen before in this sector. 

Canada in particular is at a big advantage with this shareholder-friendly strategy being in focus. Canada has some of the most unique supply dynamics in the world. We have the third-largest reserves globally, and the oilsands are responsible for over two-thirds of our overall production. 

In the U.S., shale oil requires constant discovery, capital expenditure, and drilling to maintain production. In contrast, Canadian oilsands productions require significant upfront capital investment, but once the assets are built, they benefit from minimal production decline rates and multi-decade runway for production. Canadian energy companies don’t need to invest in new growth initiatives to be profitable, so they’re generating significant free cash flow that can be distributed to shareholders. 

Finally, from an ESG perspective, on the environmental side, most companies have made medium term commitments to reduce greenhouse gas emissions from operation. Here we’re talking about 20 to 30% reductions by 2030 to 2035, and longer term we are seeing net-zero commitments being made. 

The path to achieve net-zero remains unclear, but there are steps being put in place to work towards that ultimate goal. Most notably for the oilsands producers, the Pathways Alliance is an important initiative that can go a long way to taking oilsands operations to net-zero. Pathways is an alliance of Canadian oilsands producers working together with the provincial government of Alberta and the federal government of Canada towards a carbon capture and storage solution for the emissions produced from the oilsands production. The project is expected to come online in phases with each phase taking more CO₂ out of the operations and safely storing it underground. There’s a lot of work to get Pathways to where it needs to be, but it is slowly moving forward. 

To highlight a couple of the equity picks that we like in the Canadian energy sector, we like Cenovus, ticker CVE. We think Cenovus is delivering on their existing asset base, on the Husky integration, and on the capital allocation strategy. We see potential for further optimization of operations, ongoing balance sheet strength, and further capital returns that can continue to drive the stock to outperform. We think the company’s undervalued at the current share price, and we see upside potential as they continue to deliver on key milestones. We also see significant dividend growth potential from Cenovus compared to its peers. 

Another name that we like is Crescent Point, ticker CPG. We view Crescent Point as a value opportunity in the mid-cap oil space. We see potential for Crescent Point to add value as the company continues to pay down debt, increase shareholder returns, and execute on their operations. The new management team has done a good job turning the company around since it came in place four years ago. They’ve successfully cleaned up the story, taken a lot of excess cost out of the business, and with the help of the commodity price and disciplined capital allocation, the balance sheet is now in good shape. As the company approaches its near-term debt target, we expect to see more shareholder returns from them.