Canadian Natural Resources Well Positioned to Benefit from Macro Tailwinds

Improved execution should improve execution for the company.

Jan-e- Alam
Jan-e- Alam
Apr 3, 2014 at 5:02PM
Energy, Materials, and Utilities

Canadian Natural Resources (NYSE:CNQ) has a strong financial position and some of the best oil sand assets among its peers. Cenovus Energy (NYSE:CVE), on the other hand, has a visible growth profile and Suncor Energy's (NYSE:SU) free cash flow generation capability provides increased return of capital potential. However, CNQ represents greater overall upside potential and a strong capability to generate cash flows internally. CNQ is up 19% YTD and is well positioned to benefit from the improving macro tailwinds. A favorable macro environment combined with improving operations and execution should result in further share price appreciation for the company in 2014.

Increasing cash flows and capital returns
CNQ's overall production rate decline is moderating and should allow the production volumes to grow more quickly over the next few years (approximately 50% of the company's liquids come from the slow declining assets). As the production volumes grow, free cash flows are expected to increase sharply. CNQ expects its free cash flows to increase to $1 billion in 2014 from the $200 million level in 2013. Moreover, free cash flows are expected to surge to approx. $6 billion annually from 2018 onwards. Because of the increased cash flows, the capital return to shareholders has grown at a rate of 37% annually since 2009. The rising payouts are evidence of the company's confidence that the transition toward a stronger free cash flow is well underway. According to Barclays analysts, the company could achieve long-term annual shareholder return of 20% from now to 2017 (assuming flat oil prices). This could be the sum of liquids production growth of ~13%, an annual multiple expansion of approx. 3%, and an average increase in cash flows of approx. $2 billion.

Strong portfolio of assets
CNQ boasts one of the leading asset resources bases in the sector. Its recent move toward longer-lived assets should translate into higher free cash flows, margins, and growth. The company's three major long-lived assets, Horizon oil sands, Thermal oil, and Pelican Lake polymer flood, have the ability to drive the differential performance. The Horizon projects, which are expected to generate cash flow of 20%-25% in 2014-15, could see the cash contributions increase to 35%-40% when production expands to 250 mbpd. This increase in cash flows should also lead to multiple expansion.

Strong financial position
The company is also boasting a strong financial position. The EBITDA margin is expected to increase from 50.7% in 2013 to 52.3% in 2014. The similar trend is observed for the gross profit margin, a 1.3% growth Y/Y. In addition, the net profit margin is expected to show an impressive growth of approximately 22.9% Y/Y from 13.8% in 2013 to 16.9% in 2014. The significant growth can be attributable to the operating costs saving by the management and increase in production volumes.

Source: CFS Calculations

Compelling investment opportunity
Canadian Natural Resources represent a compelling investment opportunity. It has a highly attractive oil-oriented, long reserve life portfolio with a significant expansion potential. Moreover, the company has a strong financial position and is free from the political risks inherent in many other oil companies, as 95% of its production comes from either Canada or the U.K.

The company is trading at a discount compared to its peers, which is probably due to execution risks related to the Horizon oil sands expansion and the concerns that the Canadian oil could become increasingly disconnected from the world markets if the sudden increase in oil production is not met with sufficient infrastructure investment. However, these concerns are overblown. CNQ has price/earnings ratio of 20.4 compared to the industry average of 27.4. It has a price/book ratio of 1.8 compared to 2.3 of Imperial Oil (NYSEMKT:IMO) and industry average of 1.9. Furthermore, the company has a price/sales ratio of 2.6, in-line with the industry average of 2.5. Finally it has a price/cash flow ratio of 6.3 as compared to 13.3 of IMO. Canadian Natural Resources has a dividend yield of 2.1 % compared to 1% of IMO.

Bottom line
Canadian Natural Resources has outperformed most of its E&P peers and domestic integrated oil sands companies to date. Despite of the previously plagued Horizon and the recent tightening of the Canadian oil price differentials CNQ has a promising outlook. Going forward, the company's projected strong double-digit liquids production growth allows for significant future upside, while its solid long life asset base provides sufficient downside protection.