The production cut announcement from the oil cartel last month only brought a temporary respite for oil prices. Now, the expected recession is outweighing all other factors in global energy markets.
But investors should note that even at these relatively low oil prices, producers are generating a decent amount of free cash flows. The recent Q1 2023 numbers just highlight that. With their best financial positions ever along with a fair earnings growth visibility, Canadian energy names deserve to trade at higher valuation multiples.
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TSX energy stocks versus U.S. energy
TSX energy sector was the top performer last year. However, the picture has turned upside down this year, with energy at the bottom of the chart. Both Canadian and U.S. energy stocks have lost 11% in the last three months.
Canada’s five biggest energy E&P (Exploration and production) companies collectively saw $40 billion in net income last year, marking a stellar 126% growth against 2021. In comparison, five U.S. bigwigs reported 118% earnings growth year over year.
Apart from higher earnings growth, Canadian energy producers have shown a higher capital discipline since late 2021. For example, Canadian producers have significantly reduced their leverage compared to their U.S. counterparts.
Many Canadian companies can comfortably fund their growth capital along with regular dividends with oil at around US$50 per barrel. So, we might see handsome free cash flows this year as well. Most importantly, now that the debt load has largely been tackled, excess cash will prominently go toward shareholder returns.
Solid fundamentals and depressed valuations
At the moment, TSX energy companies at large allocate around 50% of their free cash flows for buybacks and dividends. As the total number of outstanding shares decreases with buybacks, existing shares become more worthy. So, even if the company keeps the total dividend amount the same, existing shareholders will receive a higher absolute amount of dividends.
This is the main premise of higher expected returns from the energy sector in 2023 and beyond. As they have reduced debt in the last few years, they will save millions in interest expenses and will likely see higher profitability. Now, even if oil producers seek inorganic growth, they will still be left with decent excess cash on hand. So, expect higher dividends and buybacks to continue and drive higher shareholder returns for some more time.
#1 TSX energy stock
Among the entire TSX energy space, my top pick is the biggie Canadian Natural Resources (TSX:CNQ). A key driver for investor returns is the next phase of the capital return framework. The management aims to allocate 100% of its free cash flows for dividends and buybacks once its net debt falls below $10 billion. It currently has over $12 billion of net debt. CNQ will likely see this materializing late this year or early in 2024. CNQ’s leverage ratio has dropped to 0.6 times in the first quarter of 2023 from close to four in 2020.
CNQ has already been one of the income seekers’ favourites with its long reliable dividend payment history. It currently yields a juicy 4.8%.
Investor takeaway
It offers handsome total return prospects with stable dividends and capital growth. CNQ has an unmatched scale with long-life and low-decline assets. Its access to diversified markets plays well in low-price environments. A strong balance sheet, decent earnings growth outlook, and reliable dividends make it a compelling bet in the TSX energy universe.
