Canadian Oil & Gas Equities:

The disconnect from U.S. peers and the underlying commodity prices

                                                               Geoff Ho, CFA - Director, Canadian Equities, Portfolio Advisory Group

 The term brinkmanship is defined in the Webster dictionary as "the art or practice of pushing a dangerous situation or confrontation to the limit of safety especially to force a desired outcome." From our perspective, brinkmanship has been a major driving force behind market activity in recent months as governments and central banks worldwide attempt to stabilize a fragile environment plagued by sluggish economic growth and less-than-ideal credit conditions while also balancing that with political aspirations (presidential elections in U.S. and France in 2012 plus Germany in 2013) and taxpayer scrutiny. In the U.S., politicians pushed the world's largest economy to the brink of default before arriving at an agreement to raise the national debt ceiling. In Europe, central bankers and politicians are still struggling with fiscal imbalances, austerity measures, varying political views between member-nations, plus increasing tensions among taxpayers. The dangerous mix of politics and the urgent need to stabilize the global economy certainly has created a volatile investing environment recently and the risk of political brinkmanship could very well continue to be a key overhang on markets over the near- to medium-term.

 In part reflecting the above concerns, the S&P/TSX Composite Index is down approximately 14% on a year-to-date basis as investors continue to trim exposure to cyclical stocks in this uncertain economic environment. This flight from the economically sensitive sectors has had a notable impact on energy stocks as the sector is down 21% over the same period.

 The underperformance of oil and gas stocks in Canada relative to the broader index is actually quite remarkable when you consider the fact that 15% of the S&P/TSX Energy Index is represented by TransCanada Corp (TRP) and Enbridge (ENB), both of which rallied over 8.5% and 17% on a year-to-date basis, as they are generally perceived to be much more stable investments than the actual exploration and producing companies.

Looking at some of the large-cap energy producers such as Suncor (SU) and Talisman (TLM), the shares are down 31% and 41% respectively since the start of 2011, drastically underperforming a number of other sectors and also the underlying commodities as the price of crude is off 12% thus far in 2011 while the price of natural gas has fallen 15.5%.

Furthermore, it is worth noting that the energy sector in the U.S. is off a more modest 12.5% so far in 2011, materially outperforming their peers in the north.

In the following sections, we attempt to provide some rationale for the weak performance of the Canadian oil and gas equities relative to their U.S. counterparts and to the underlying commodities. Generally, we acknowledge that some of the underperformance is warranted but in light of this recent correction, we believe that shares are already discounting a reasonable amount of risk.

At current levels, given the current macro uncertainties marked by sluggish economic data and the risks of political brinkmanship over the near-term, we are reluctant to materially increase the weighting of the energy sector in a portfolio. However, for those that are underweight the sector or are looking for switch opportunities to capitalize on better risk/reward opportunities, we believe that the Canadian oil and gas stocks present a compelling opportunity at current price levels. Until there is more clarity on the European debt situation and until there is some confirmation that this is merely a mid-cycle slowdown in the economy, we continue to recommend a focus on large-cap equities.

 Canadian Energy Sector versus U.S. Peers

 There has been a noticeable divergence in the performance of the shares of Canadian energy companies versus their counterparts south of the border. On a year-to-date basis, the S&P Energy Index in the U.S. has outperformed the Canadian companies by a material 8.5%.

 Some of the reasons for this discrepancy relates to:

The Cushing glut. Canadian oil production has been gradually increasing over the years and industry observers indicate that this has caused a significant bottleneck effect at Cushing, the delivery point for the benchmark West Texas Intermediate futures contract.

 While there is sufficient transport capacity to export the product into the United States to the Cushing hub, it appears that storage levels there remain at fairly lofty levels. Analysts believe that new pipelines such as the proposed Keystone XL line and growing demand from Asia will help to alleviate this bottleneck over the next few years but for now, the glut at Cushing could continue to be an issue for Canadian producers given that long-term production growth will partly depend on export capacity.

 Foreign exchange factors. The strength of the Canadian dollar could be less advantageous for domestic producers relative to their U.S. peers. On the revenue line, the price of crude oil is typically priced in U.S. dollars and as such, there is a negative translation effect for Canadian companies when sales are converted back to their reporting currency. This is particularly meaningful given that it is likely that a substantial portion of their operating costs are in Canadian dollars.

 Generally speaking, other company-specific factors aside, an appreciating Canadian dollar could make the operating margins of Canadian companies relatively less robust than their U.S. peers.

 􀂃 Different cost structures. Depending on the extraction method, costs can vary significantly among energy producers. Of late, it appears that companies mining for the commodity (versus other extraction methods such as Steam Assisted Gravity Drainage or SAGD) have reported higher relative expenses as a result of rising costs for items such as energy and labor.Accordingly, for companies that mine for oil (ie. Suncor, Canadian Natural Resources, and Canadian Oil Sands), some investors are now gradually factoring higher cost structures for these producers.

􀂃 Supermajor status.   Supermajor is a name used to describe the world's five, and at times six, largest publicly owned oil and gas companies, that in aggregate represents approximately 6% of global oil and gas reserves.Exxon Mobil (XOM-NYSE), one of the supermajors, is the largest energy company in the U.S., boasting a market cap of US$350 billion. By contrast, Canada's largest integrated energy company by market capitalization is Suncor, which has equity value of C$44.3 billion.

Accordingly the size and scale of the operations between the producers are drastically different. Generally, large cap energy plays in the U.S. typically boast higher credit quality than the Canadian large-cap energy plays as they present more sizeable operations with less leverage. That said, however, by no means does this imply theproducers in Canada are over-levered.

 􀂃 Political and environmental concerns. The oil sands regularly face criticism for its carbon-intensive production process and certain groups (environmentalists, government bodies, etc.) have lobbied to reduce reliance on "dirty oil". This has been an ongoing debate and will likely continue to be so for some time. While this creates negative headline news, our opinion is that, the benefits of the oil sands (friendly political environment, significant resource base, improving technologies helping to reduce emissions) outweigh such concerns. Nonetheless, this occasional criticism of the oil sands could possibly also help to explain the underperformance of the Canadian energy sector relative to the U.S. producers.

􀂃 More natural gas companies in the Canadian index. The price of natural gas remains fairly weak given a sluggish economic outlook, record supply levels, and a significant backlog of drilled wells that are near completion. Depressed natural gas prices and a rather bearish near-term outlook for the commodity have certainly had a negative impact on the share price performance of the related producers.

Given that there are more natural gas companies included in the Canadian index, and considering that the price of oil has held in relatively well compared to natural gas prices, one can rationalize some outperformance by the S&P Energy Index in the U.S.

Disconnect between commodity prices and equities

The price of crude oil is currently down 12% since the start of the year while the price of natural gas is down 15.5% over the same time period. By contrast, the S&P/TSX energy sector has lost 21% in value since the start of the year. At current levels, the spread between the price of the underlying commodities and the S&P/TSX Energy Index is approaching six year highs and hovering near levels not seen since the distressed period in 2008 when Lehman Brothers filed for bankruptcy protection.

There are various factors that can influence this diverging price performance, including:

􀂃 Investors are discounting lower future crude prices. While the WTI spot price is trading north of US$80 per barrel at the moment, the share price of a number of the senior producers are effectively discounting US$70 per barrel over the longer-term horizon.

Put differently, investors are using lower oil price assumptions in their long term cash flow and valuation models. Given the lingering concerns over European debt issues and the chance of yet another global recession, one could certainly make a case for near-term downside risks in the spot price of crude. Based on the current uncertainties, this downside risk could possibly be fuelled by improving weather conditions that have impacted production in the Gulf region and/or subsiding geopolitical risks in the Middle East.

􀂃 Higher operating costs, less leverage to crude prices.A number of producers have cited materially higher operating costs in recent quarters. Accordingly, if costs are rising at a faster pace than the price of the underlying commodity, margin pressure results in relatively lower returns for shareholders of these energy producers. Effectively, every incremental dollar increase in oil prices does not necessarily flow directly through to the bottom line.

􀂃 Preference for owning the commodities. As with any company irrespective of the sector, energy producers are subject to environmental, regulatory, and operating risks. As such, some investors ultimately prefer to own the underlying commodity instead of shares of a company in an effort to avoid company-specific risks. This preference of select investors could also influence the performance of commodities versus the related equities.

Summary

 Reflecting some of the considerations above, we believe that the lagging performance of the Canadian energy sector relative to their U.S. counterparts and the underlying commodity prices is not entirely unwarranted. That said, the magnitude of the underperformance appears to be rather extreme with a number of the senior energy producers effectively discounting an oil price of US$70 per barrel at the moment. As well, while most energy stocks are still trading approximately 30% above the lows of March 2009, it is worth noting that the last time names such as Suncor and Talisman traded down to these levels, the price of crude was actually around US$45 per barrel.

 Accordingly, in our opinion, the recent correction has created some opportunities as the risk/reward profile of the Canadian energy sector becomes increasingly attractive. Although the stocks have yet to put in a definitive bottom from a technical perspective, one modestly positive signal is that at current prices, there has been a noticeable rise in share buybacks and insider buying.

For investors who are underweight the sector or are looking for switch opportunities, the oilweighted large-cap senior producers in Canada present compelling value.

 We caution there could be some near-term downside risk to the price of crude given the recent sluggish economic data and the risks of political brinkmanship. As such, we would prefer to slowly and gradually accumulate on weakness.

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The supervisors of the Portfolio Advisory Group own securities of the following companies. Suncor Energy Inc., TransCanada Corporation, Scotia Capital USA Inc. or its affiliates has managed or co-managed a public offering in the past 12 months. Enbridge Inc., Talisman Energy Inc. Scotia Capital USA Inc. or its affiliates has received compensation for investment banking services in the past 12 months. Enbridge Inc., Suncor Energy Inc., Talisman Energy Inc., TransCanada Corporation

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