The Best Oil Stocks to Buy as Crude Prices Surge – Our Favorite is CNQ

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Thesis article

Oil and oil-related stocks have done well lately. The macro picture was helpful as oil prices hit multi-year highs. At the current level of commodity prices, many oil producers will be extremely profitable – compared to this, some are still pretty good value. In this report, we will highlight a few oil stocks at attractive prices, with Canadian Natural Resources (NYSE: CNQ) being our first choice.

macro photo of oil

The current war between Russia and Ukraine has pushed oil prices well above $100 a barrel. WTI is trading around $115 per barrel at the time of writing, but prices have been very volatile, moving several dollars in a single day over the past two weeks.

Even before the current crisis, oil prices were quite high and the macroeconomic picture was compelling. In mid-February, oil was trading in the $90 range, the highest level seen since 2014. So the current war has not lifted oil prices from low to high. Instead, the Russian-Ukrainian war pushed oil prices from an already relatively high level to an even higher level.

Oil prices were trading above $90 a barrel before this crisis due to strong fundamentals. The economic reopening around the world has led to a surge in demand. At the same time, energy companies around the world have invested reluctantly for many years since the oil price crash in 2014. Very low oil prices during the initial phase of the pandemic have further amplified the reluctance to spend for new projects. Due to high demand for oil and weak growth in supply, the macroeconomic situation for oil was therefore positive even before the Russian-Ukrainian war.

In this environment, oil companies are very profitable. This is the case with oil in the $80 or $90 range, and even more so with oil trading well above $100 a barrel.

1: Canadian Natural Resources

Canadian Natural Resources is an oil sands player in Canada. The Company’s assets have a very long reserve life and low rate of decline, as well as low commensurate costs. Setting up an oil sands mine is quite expensive, but once these high initial costs are paid, the asset is a low-cost cash flow machine for many years. Canadian Natural Resources has set up these assets in the past, which means investors can reap the benefits of these low-cost, low-decline assets in the future.

Even before the recent surge in oil prices, CNQ was a cash flow monster. During the fourth quarter, CNQ generated free cash flow of approximately C$2.9 billion. This equates to approximately US$2.3 billion. CNQ was therefore operating with a free cash flow rate of over $9 billion during the fourth quarter – when oil prices were much lower than they are today:

Chart
Data by YCharts

We see that WTI mostly traded around $80 in the fourth quarter, with prices in the $60s at the start of December. The fourth quarter average was therefore somewhat below $80 a barrel, and yet CNQ generated massive cash flow. In 2021, oil prices are much higher, on average, so far. On top of that, CNQ has been aiming for production growth of a few percentage points this year. Between production growth and oil price tailwinds, CNQ’s annual free cash flow is expected to climb several billion dollars this year, compared to the rate in the fourth quarter. I estimate that free cash flow would total about US$15 billion per year if oil averaged $100 for the entire year. It’s not certain that oil is this high all year round, of course. But it looks likely that oil prices will stay above the high $70 seen in the fourth quarter, which should lead to free cash generation well over $9 billion this year, especially once that we will take into account the production growth expected this year.

Considering CNQ is valued at just $72 billion today, the valuation is very attractive. At the fourth quarter run rate, CNQ offers a free cash flow yield of 13% and trades at a free cash flow multiple of just under 8. Given macro tailwinds from higher oil prices , it looks very appealing. The company has deleveraged its balance sheet in recent years and now expects more free cash flow to be used for shareholder returns than in the past.

Management thus increased the dividend by 28% in March, which is one of the largest dividend increases both in the company’s history and compared to what other major oil producers have offered. these last years. The new dividend, which yields 3.8%, is covered at a rate of 3.4x at the level of the free cash flow of the fourth quarter, while the coverage rate is 5.5x based on my estimate of the free cash flow of free cash in a $100 oil price scenario. Clearly, CNQ has largely excess free cash flow, even after this huge dividend increase. Further deleveraging will likely result, but the company also plans to buy back shares aggressively. The company’s current repurchase authorization allows Canadian Natural Resources to repurchase 102 million shares, or approximately 10% of the company’s share count. Depending on the average oil price this year, CNQ may be able to complete the entire program in a single year. For reference, CNQ repurchased about 5% of its shares last year when oil prices were considerably lower than they are now. To me, this indicates that investors can expect high redemption yield going forward, as long as oil prices remain at attractive levels of $80, $90, $100 or even higher.

2: Exxon Mobil

Exxon Mobil (XOM) is one of the largest integrated oil companies in the world. Despite its $350 billion market capitalization, however, the shares are not expensive at current prices. The company generated $31 billion in free cash in 2021, which equates to a free cash flow yield of about 9% at current prices. This still does not take into account that 2022 will most likely be a considerably stronger year than 2021. Growth in production from low-cost assets such as the Permian Basin or XOM’s Guyana assets, as well as material prices significantly higher raw should increase Exxon Mobil’s cash position. generation noticeably this year.

Exxon Mobil - Cumulative Estimated Sources and Uses of Cash

XOM presentation

In the chart above, we see XOM indicating that its dividend and capital program is safe with oil trading as low as $35 a barrel. With oil trading at $60 a barrel, XOM would generate free cash flow of around $200 billion in 2022-2027, or just over $30 billion per year. Oil prices are currently about $55 above the price per barrel used by Exxon Mobil in the estimate above. Using back-of-the-napkin math, XOM, with liquids production of around 2.4 million barrels per day, could generate free cash flow of $60 billion per year with Brent at $100 le barrel. Today, the price is considerably above this level, indicating even higher cash flow. Under a $60 billion free cash flow scenario, XOM would trade with a free cash flow yield of 17%, showing the stock’s potential if oil prices remain high.

3: BP

BP (BP) is another supermajor that is trading at a very cheap valuation and is expected to generate huge free cash flow this year.

BP free cash flow generation

Presentation BP

In the chart above, we see the outlook for free cash generation for different oil price scenarios. The most aggressive uses a Brent price of $80 per barrel – at the time of writing Brent is trading at $119. With oil at $80, BP would generate about $15 billion in free cash a year, with capital expenditure already accounted for. Extrapolating the projected free cash flow growth between the $60/bbl scenario and the $80/bbl scenario, I think free cash flow will reach around $20 billion if Brent averages $100 this year. In this scenario, which involves a reduction compared to current oil prices, BP’s free cash flow yield is 20%, because BP’s market capitalization is only $100 billion today. Considering that investments in the oil and gas portfolio, as well as investments in new energy assets are already accounted for, a free cash flow yield of 20% is incredibly attractive. The dividend yield is slightly above 4% at the moment, the remaining available cash would be used either for buybacks or for debt reduction.

Take away

Oil prices have surged due to the ongoing war between Russia and Ukraine. But even before this crisis, the macroeconomic situation in the energy sector was very constructive. Underinvestment, combined with strong demand growth, could lead to a multi-year bull market for oil and oil stocks.

Many oil stocks are still cheap at current valuations. This includes Canadian Natural Resources, Exxon Mobil and BP. All three offer strong dividend yields, redemptions and considerable upside potential if oil prices remain high.


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Felix J. Dixon