2 High-Quality Canadian Energy Stocks

The Canadian energy sector is benefiting from weakening of the Canadian dollar and the narrowing price differential between Canadian heavy crude and West Texas Intermediate (WTI). In the current scenario companies such as Suncor Energy (NYSE: SU  ) and MEG Energy (TSX: MEG  ) , which have solid track records of delivery and strong asset positions, should be the focus of investors' attention. Both Suncor and MEG are high-quality producers with exposure to growing oil production. Canadian Natural Resources (NYSE: CNQ  )  is also well positioned to benefit from this favorable scenario.

Production to grow significantly
After a year of extreme volatility, punctuated by export constraints and deep discounts on heavy oil, things are looking much better for the Canadian oil sector. Lately the large-cap Canadian E&P sector has been dominated by rapid growth in heavy oil production, driven mainly by oil sands growth. The Canadian Association of Petroleum Producers (CAPP) is forecasting Canadian oil production to grow from 3.5 million barrels per day (mbpd) in 2013 to 4.2 mbpd through 2017. Furthermore, CAPP predicts production will grow to 6.7 mbpd by 2030 (almost double 2012 production of 3.2 mbpd). This forecast includes the oil sands production of 5.2 million barrels per day by 2030, which is up from 1.8 million barrels per day during 2012.

Price differentials expected to narrow
Despite significant growth in production, the Canadian heavy oil differentials are expected to narrow year on year. This is primarily driven by the increased rail capacity, the start-up of Flanagan South-Seaway Twin in the second half of 2014, Keystone XL South, and the increased heavy oil demand driven by the start-up of Whiting and restart of CITGO.

The gap between the prices of Western Canadian oil and WTI has largely been due to poor infrastructure. The flow of oil from Canada to the U.S. is becoming increasingly difficult. While more and more companies are shipping oil by rail now, the approval of Keystone XL can largely resolve the supply problem. Nevertheless, the extended periods of elevated differentials are behind us now, and there appears to be ample takeaway capacity through 2017. However, beyond 2017, alternative solutions such as Northern Gateway, Keystone, Energy East, the Trans-Mountain pipeline expansion, and the Line 9 reversal may be required.

Suncor Energy
Suncor Energy is the best positioned stock in the Canadian large-cap sector. The company offers investors a compelling combination of an advantaged integrated business model, low political risk, an above average long-term production growth profile, and strong free cash flow generation ability.

The company is also strategically positioned. It is one of the few companies with its onshore North American production naturally hedged by a significant downstream segment. Suncor's strategy of optimizing its current asset base and returning more cash to its shareholders has also resulted in higher returns and a more balanced outlook for production growth. Suncor recently increased its dividend by 15%.

Finally, despite a strong profile, the company is trading at a discount compared to its large-cap North American peers. Suncor has forward price/earnings and price/book ratios of 11.4 and 1.4 respectively compared to 12.5 and 2.4 for ExxonMobil. Warren Buffett also considers Suncor a value buy and invested more than $500 million (~18 million) in Suncor last year. Although his company Berkshire Hathaway sold 5 million Suncor shares in December, Berkshire Hathaway still owns ~1% of the company.

MEG Energy
Driven by significant cash flow growth potential, a differentiated marketing strategy, and its transition toward the self-funding model, MEG Energy is another Canadian large-cap E&P company looking at a strong 2014.

MEG is a high growth oil sands producer and offers investors a portfolio of premium assets and several key strategic advantages. The company is among the lowest cost producers in North America. The company's development projects have a full-cycle cost of supply in the $35-$55 per barrel range. Moreover, these projects are expected to drive annual average production growth of 25% through the end of the decade. Finally, MEG's early emphasis on infrastructure and marketing arrangements provides another key strategic advantage to the company.

Despite a superior growth profile through the end of the decade, MEG is trading at a discount compared to its E&P peers. However, this should change, and the company should see its multiple expand as its cash flows approach capital expenditures and financial risk is reduced later this year. The significant production and cash flow growth over the next twelve months, and the de-risking of the company's future development phases, should result in share price appreciation and narrow the discount it trades at compared to its peers.

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