Description

As the oil markets will begin focusing on the declining drilling inventories for Permian drillers, we think that it is a good time to re-visit the Canadian oil sands. These companies have visibility into 40+ years of reserves and are more insulated from service cost inflation, which will likely result from the steeper decline rates of shale production. As a result, the oil sands' producers capital expenditures will be more stable and predictable going forward. 

A risk to owning oil sands assets is that natural gas is a key input for SAGD producers. Typically, they are short natural gas, which provides energy for the steam generation. MEG Energy has a natural hedge in its business as it is long power generation, which it sells into the grid. This dynamic cushions any potential reversal in the oil/natural gas ratio. See the chart below for the sensitivity. A $0.50 change in the price of natural gas reduces cash flow by only C$2 million.

As shown in the table above, differentials are another key variable to MEG. During the last 2 quarters (4Q22 and 1Q23), differentials widened above their historical average due to lower Chinese demand out of the Gulf Coast (largest buyer of AWB out of the Gulf Coast), refinery outages and maintentance work, and releases from the SPR. Towards the end of 1Q23, differentials narrowed thanks to improved Chinese demand, increased heavy refining capacity, reduced SPR releases, and OPEC production cuts which are biased towards heavy crudes.

There should be a structural change in the Canadian heavy crude market when the TMX pipeline expansion is complete in 1Q24. This will increase the pipe's capacity from 300 Mb/d to 890 Md/d to move mostly incremental heavy crdue from Alberta to an export facility at Burnaby, British Columbia. Some of those barrels will be exported to the U.S. West Coast, while other voluems will move to Asia - most likely China. It will not be moving to legacy destinations - Midcontinent refieries via the Enbridge Mainline, Keystone and other pipes. When those barrels shift to the BC export market, two things will happen. First, the price spread beween Canadian crudes and WTI will narrow as US refiners bid up the price to hold onto some of the Canadian barrels. Second, Canadian crude flows to the U.S. will decline for a year or two until production volumes catch up with the new demand.

Over the past couple of years, MEG has been focused on deleveraging. It is nearing its goal of reducing debt to $600 million. Until the debt load reaches this level, only 50% of MEG’s free cash flow will go towards share repurchases. Once the debt is brought below $600 million, all of the company’s free cash flow will be utilized to repurchase shares. It is hard to envision how the stock does not appreciate meaningfully if crude prices are at or above $80 per barrel. As illustrated below, assuming $80 WTI, the company will be able to buy back 95% of its market capitalization over the next six years. Assuming shares are retired at 10x free cash flow (currently at 5x free cash flow), free cash flow per share will grow to $5.87 per share in 2028. When assuming $100 WTI from 2024+, the strong leverage that the stock has to crude becomes apparent. The company will be able to buyback 125% of its current market capitalization and free cash flow per share in 2028 will be $9.00 per share.  At this point the company will still have roughly a 30-year reserve life. It is noteworthy that the Permian Basin will likely have peaked by this time. This means that oilfield service utilization will have to increased markedly to bring the same amount of production.

Catalyst

TMX expansion completed

Debt reduction below $600 million (a 2024 event)