The oil and gas index returned an impressive 46.3 per cent in 2000 and was the third-best performing sector within the TSE 300.
The performance of the oil and gas sector was only slightly behind the 47.9-per-cent increase recorded by the financial service sector and the 46.6-per-cent return achieved by the pipeline group.
Although the oil and gas index had a superb year in 2000, share prices have substantially under-performed relative to the improvement in commodity prices. Even with the incredible returns of the oil and gas sector, it can be argued that the sector is still significantly undervalued. The group is trading at four times ScotiaMcLeod’s estimate for 2001 cash flow, a level well below the historical average of approximately six-and-a-half times cash flow estimate.
These estimates are based on an average West Texas Intermediate oil price of $27 per barrel, and an average wellhead price for natural gas of $5.50 per thousand cubic feet.
A catalyst that may drive share prices higher is the potential for further consolidation in the industry.
First, Canadian oil and gas companies have displayed exceptional financial discipline and have strengthened their balance sheets considerably. During the past year, companies have used their strong cash flows to reduce debt and repurchase shares. These companies are now financially well positioned to contemplate acquisitions.
Second, with strong commodity prices, the cost of purchasing assets has appreciated. In today’s environment, it is often cheaper to grow through acquisition than it is to purchase assets or expand through exploration.
Third, a significant number of oil and gas companies are trading below the underlying value of their assets. Based on research from ScotiaMcLeod’s oil and gas analysts, 85 per cent of the 31 companies they cover are trading below their net asset value. With only eight of Canada’s top thirty-five oil and gas companies having control blocks, it is reasonable to believe that virtually every Canadian oil and gas company can be considered as a takeover candidate.
Conversely, companies that are trading at low valuations have been exploring alternatives to enhance their share price. Founders Energy and Danoil Energy are two companies that have attempted to maximize shareholder value by converting their companies into royalty trusts.
Oil and gas royalty trusts differ from traditional oil and gas companies by distributing the majority of earnings to shareholders instead of maintaining earnings within the organization for future growth. In today’s strong commodity environment, many royalty trusts are projected to return about 20 per cent of an individual’s initial investment within the first year.
Since their announcements, Founders and Danoil share prices have appreciated 42.5 per cent and 12 per cent, respectively.
In an attempt to maximize shareholder value, traditional oil and gas companies are also analysing the possibility of merging with existing royalty trusts. Cabre Exploration, Startech Energy and, most recently, Cypress Energy have all enhanced shareholder value by merging with existing royalty trusts.
Despite the strong performance of the oil and gas index last year, oil and gas companies are still trading at low valuations. With analysts forecasting strong commodity prices and with the possibility of further consolidation in the industry, the outlook for oil and gas companies appears encouraging for the remainder of the year.
(Derek Ballendine is an investment executive with ScotiaMcLeod Inc. These views and ideas belong to Derek Ballendine and do not necessarily reflect the views and ideas of ScotiaMcLeod.)
