How Canada’s Emissions Cap Could Impact the Value of Oil and Gas Giants

KEY TAKEAWAYS

§? Canada's proposed emissions cap could significantly affect oil and gas production, with potential financial implications for key players.

§? Top Canadian oil and gas companies have a combined market valuation of nearly $200 billion at the end of 2023.

§? There is a strong positive correlation between oil reserves, oil production, and market cap, underscoring the critical role of production in companies’ market value.

§? A 25% decline in production could translates to a $56 billion value loss, highlighting the financial vulnerability from regulatory changes.

INTRODUCTION

The Government of Canada is committed to reducing greenhouse gas emissions. To this end, the government has proposed draft regulations to cap greenhouse pollution from oil and gas production to 35% of its 2019 levels by 2030. Several stakeholders have argued (here, here, and here) that the emissions cap is effectively a cap or reduction on the level of oil production. Yet, the government’s own analysis of the proposed cap suggests that oil and gas production could still increase by 16% between 2019 and 2032, slightly lower than the projected growth of 17% without the emission cap.

Kenneth Green of The Fraser Institute disagrees. He asserts that the cap will inevitably curtail oil and gas production in Canada. Additionally, Green points out that the cap will harm Canada’s nascent and growing petrochemical and plastics manufacturing sectors, located in Alberta, Ontario, and Quebec and which relies on crude oil feedstock.

In the few days since the federal announcement, much attention has been focused on the impact of reduced oil production on the economy, on jobs, ability of the government to fund critical infrastructure and social programs. However, what will such a production cut mean for the fortunes of Canadian upstream oil and gas companies?

To address this, we turn to the Oil & Gas Journal (OGJ). The OGJ conducts several surveys, including a survey of the top 100 non-US oil and gas companies. In their 2023 survey, the fourteen Canadian oil and gas companies captured on that list produced 3.23 MMbpd of oil, representing 3% of global oil production.

In this article, we will rely on the OGJ list to characterize the top Canadian oil and gas companies based on their key performance metrics. Additionally, we will examine what a potential reduction in production implies for the market valuation of these companies.

Let’s dive in!

LONELY AT THE TOP?

There are fourteen Canadian oil and gas companies that appear in the OGJ top 100 non-US oil and gas companies. These are:

1.??? Advantage Energy LLC

2.??? ARC Resources Ltd.

3.??? Baytex Energy Corp.

4.??? Canadian Natural Resources Limited (CNRL)

5.??? Cenovus Energy

6.??? Crescent Point Energy

7.??? Gran Tierra Energy

8.??? Imperial Oil

9.??? Obsidian Energy Ltd.

10. Paramount Resources

11. PEYTO EXPLORATION & DEV CORP

12. Suncor Energy

13. Touchstone Exploration Inc.

14. Vermilion Energy

We note that Crescent Point Energy Corp. changed its name to Veren Inc.

The oil and gas industry is generally divided into upstream, midstream, and downstream. Upstream companies engage in crude oil and natural gas exploration and production (E&P). This entails searching for oil and drilling wells to produce the oil and gas reserves.

The Canadian companies listed in the OGJ top 100 non-US companies maintain a significant footprint in the upstream segment of the Canadian oil and gas industry.

These companies and their corresponding financial and operational metrics are captured in Tables 1 and 2, respectively.

In 2023, these companies together had a market capitalization of ~ $200 billion, raked in revenue of ~ $170 billion and commanded total assets of ~ $250 billion. On aggregate we see a total net income of $22 billion, with losses recorded for Baytex Energy Corp. , Gran Tierra Energy , Touchstone Exploration Inc. , and Vermilion Energy .

Table 2 presents the underlying oil assets – which form the core of the companies’ operations and value.

From their worldwide assets, these companies produced a total of 3.23 MMbpd of oil, and 6.72 Bcfd of gas in 2023. Additionally, they sit on 26 billion barrels of oil reserves and 33.4 Tcf of gas reserves. If these companies were a country, they would account for 1.5% of global oil reserves ranking above Qatar and be the 5th largest oil producer in the world.

Let’s have a look at the performance metrics of this cohort of oil and gas companies.

PERFORMANCE

We will assess the cohort’s oil and gas asset performance using the reserves – production index, while the financial performance will be evaluated using the market capitalization and return on assets.

The Reserves – Production Index

The reserves production index is an important metric and indicates how long the company’s reserves can be produced at its current production rate. For upstream oil and gas companies, their oil/gas reserves represent their major asset.

However, to generate cashflows (which is marked to value), the reserves must be depleted by producing oil and/or gas. As such, the reserves-production index is an important element in determining the value of an E&P company.

In the following table, we capture the R-P index for oil and gas separately.

Canadian Natural Resources has the highest oil R-P index at 32 years, while the least index is due to Gran Tierra. The average oil R-P index of the cohort is 15 years.

For gas, Touchstone Exploration yields the highest R-P index of 141 years. This is due to the low gas production of 3 MMScfd relative to its huge reserves of 141 Bcf. The companies at the lower end of the gas R-P index are Gran Tierra, Imperial, and Suncor.

The average gas R-P index is 23 years, and the median R-P index is 11 years.

While a higher R-P index suggests that the company has long years ahead to produce its assets, the market may view this negatively. The market will prefer companies that “front-load” production and hence result in lower R-P ratio for a given reserve size – all else equal.

Ranking of Market Capitalization

Market capitalization, or "market cap," represents the total dollar market value of a company's outstanding shares of stock. It is obtained by multiplying the number of outstanding shares of the company by the current market value of one share. This is considered the market value of the company.

I rank and plot the market cap values of the companies. These values are as of the end of 2023.

Leading the cohort in terms of Market cap is Canadian Natural Resources ($70.13 billion), followed by Suncor at $40.85 billion, Cenovus at $30.85 billion, and Imperial at $30.16 billion. These four companies account for ~ 90% of the market capitalization of the cohort.

Ranking of Return on Assets (ROA)

The ROA metric allows us to assess how efficiently the company uses its assets to generate returns. It is obtained by dividing the net income by the total assets. The graphic in Figure 2 shows the ranking of the ROA.

ARC resources leads the cohort with a 12.66% ROA. This is followed by Imperial (11.87%), Canadian Natural Resources (10.64%), Paramount (10.51%) and Suncor (9.19%).

Of the four companies that account for 90% market cap of the group, only two – Canadian Natural Resources and Imperial Oil – have positive double-digit ROA and are in the top four by ROA.

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DRIVERS OF VALUE

Several factors drive the value of an oil and gas company. These include:

-????? Reserves Sizes

-????? Oil Production

-????? Oil to gas production ratio

-????? Degree of vertical integration

-????? Ownership

-????? Geographical spread

-????? Level of debt

However, with the energy transition in play and pursuit of net zero policies, a new factor impacting market-based valuation of oil companies has arrived.

Meeting the net zero target is hinged on reducing oil supply as well as the demand for oil. We will examine how the reduced production following the Canadian government’s proposed cap on emissions can impact these top Canadian oil and gas companies’ valuation.

Correlation Heat Map of Market Capitalization and Other Factors

The correlation table shows the correlation coefficients between variables. Usually, the table is colour-coded to represent the strength and direction of the correlation between the variables.

Table 4 is the correlation heat map between the Market Cap and six other variables. They variables include:

1.??? Oil Production

2.??? Gas Production

3.??? Oil Reserves

4.??? Gas Reserves

5.??? Net Income

6.??? Total Assets

The heat map indicates that market capitalization is positively and strongly correlated (>0.90) with oil production (0.97), oil reserves (0.97), net income (0.94), and total assets (0.93). Although market cap positively correlates with gas production (0.76) and gas reserves (0.66), it is not at the same strength as the others.

Total Assets is strongly and positively correlated with oil production (0.96), oil reserves (0.86), net income (0.98). Total assets is positively correlated with gas production (0.58), and gas reserves (0.38). However, the strength of these relationships isn’t as strong as that with oil.

The table suggests that oil production and oil reserves exert a higher influence on the market cap of the top Canadian oil and gas companies than gas does.

Market Capitalization and Production

We show the relationship between market cap and oil and gas production for our cohort of companies. We do this by analysing a cross section of the fourteen oil and gas companies for year ended 2023.

The plot in Figure 3 is a scatterplot of the companies’ market cap (in $MM) versus corresponding oil and gas production (in MMboe). As deduced from the heatmap and noted from the graphic, there is a positive relationship between the companies’ market cap and their oil and gas production.

For technical reasons, I have presented the data points on a “log-transformed” axis with the corresponding predictive model.

Beyond the slight statistical nuance above, Figure 3 implies that oil and gas production and Market capitalization move in the same direction.

The key takeaway, therefore, is that any measure that will lead to a reduction or decrease in production of this cohort of companies will negatively impact their market valuation – all else equal.

Table 5 below provides some hard data points from our model. Using Canadian Natural Resources (market ticker symbol: CNQ) as an example, we show the impact on the company’s market cap if its production declines from its 2023 level.

A 5% decline in production would lead to a decline market capitalization of $4 billion. While production declines in the 25% level would lead to loss of $20 billion in the market value of the company. This is a 29% shave off the value of the company.

Extending this to our cohort of top Canadian oil and gas companies, a 25% decline in production from 4.43 MMboe/day to 3.32 MMboe/day will result in market valuation loss of $56 billion. That is no small change.

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