Is the long-term case for Canadian energy better than it appears?

While Canada’s energy sector has suffered a wave of divestment as investors embrace the thesis of a net-zero transition by 2050, it could nevertheless provide a valuable opportunity over the long term.

That’s the key message in a new white paper, which suggests an upside scenario for the energy sector even as the world goes through its long-tail green transition.

“We see risks with this transition scenario, which we think will be longer than the market thinks,” says Stu Morrow, chief investment strategist at Morgan Stanley Wealth Management Canada and lead author of the report.

A longer runway for EV adoption

While the report doesn’t argue against electric vehicles as the wave of the future, it suggests more time will be needed for the technology to fully replace the internal combustion engine. Apart from a scarcity of the metals required for EV battery production, the report says there are supply-demand issues with the batteries themselves that have yet to be unkinked.

A fully electrified future, Morrow notes, will also require an upgrade to the world’s existing power grid. Aside from coordination and time, he says the world still has to grapple with the financial costs of that shift – costs that have doubtlessly increased given elevated nominal and real interest rates worldwide. Morrow also sees a lopsided supply-demand picture for oil, with the world’s thirst for oil not ebbing as fast as supply.

“For those investors who don’t have ESG constraints, investing in the energy sector can provide some downside protection to portfolios, especially if supply remains tight,” he says.

In the last couple of months, Morrow notes, the energy sector has performed well on the supply shock, helping to counterbalance the impact on the rest of the market. While the report is meant to provide a long-term thesis, he expects that type of short-term movement to be a recurring motif over time.

Canadian energy: a picture of sustainability

From a valuation perspective, the report paints a compelling portrait of Canada’s energy sector, which is trading at a discount compared to peers. Particularly worth noting for investors, Morrow says, are the sector’s higher dividend yields relative to the TSX as well as the US energy sector. Dividend yield for the S&P/TSX Energy index as of August was 5.6%, while free cash flow was 8.4%.

The report also describes how Canadian energy producers are adopting two green investment strategies – “maintenance ESG” and “growth ESG” – which has helped make Canadian oil preferable to other regional options from an ESG scoring perspective.

“The Canadian energy sector looks to be sustainable in terms of paying dividends, its debt, and meeting its emission targets. Even if WTI goes to $65 a barrel, it’s a sustainable sector based on our work,” Morrow says. “[Canadian energy producers’] balance sheets are less operationally geared and supported by this free cash flow which goes back to their being more capital-constrained than they have been relative to history.”

Aside from current income, Morrow says investors in Canadian energy stocks could potentially experience dividend gains over the medium and long term. The sector is trading at a historical discount – roughly half of its long-term price-earnings ratio, as well as on an EBITDA basis. At least part of that, he says, could be attributed to potentially bad news that’s being priced – and perhaps overestimated – in those names in the sector.

Investors in the Canadian energy space, Morrow stresses, shouldn’t expect smooth sailing. Over the last five years, he says the sector’s beta sensitivity to the overall index is sitting at 1.32, even higher than the US energy sector. And while the Canadian energy space rose 5% in contrast to the 5% fall in the TSX in the last three months, exposure during the first six months of the year would have produced the opposite experience.

“Total portfolio diversification is important,” Morrow stresses. “Investors may already have exposure to the Canadian energy sector if they own a Canadian mutual fund or a passive Canadian index fund. So they need to be mindful that adding exposure does add concentration risk to the portfolio in isolation.”