Energy Bounce-Back

Suddenly energy stocks are sexy again. How quickly things change!

Back in January, I wrote that the sector was in a state of uncertainty, faced with a shortage of delivery capacity and forced to accept deep discount pricing. In December, Western Canadian Select had fallen to a record discount of $42.50 a barrel compared to West Texas Intermediate (WTI) crude. The Premier of Alberta expressed concern and frustration over the “bitumen bubble” as oil and gas stocks languished.

The markets reflected this angst in the first half of the year. The energy sub-index, one of the most important components of the TSX, was off by 2.3% for 2013 as of the end of June. But what a difference a month makes! Energy stocks turned around in July, posting a gain of 5.7% as of the close of trading on July 26.

What happened? In simplistic terms, all the stars aligned. Well, almost all of them – we’re still awaiting word on the fate of the Keystone XL pipeline which could be the biggest catalyst of all.

Obviously, the increase in oil prices in recent weeks has been one of the main drivers in the sector’s rebound. It’s not just the fact that the WTI price has soared to well over $100 a barrel. Equally important is the fact that it is now trading at close to par with North Sea Brent, which has been priced at a premium for years. For Canadian producers, the fact that the discount on Western Canadian Select has dramatically declined is also critical. As of July 23, Bloomberg reported that the discount was down to $22 a barrel.

Unrest in Egypt and other parts of the Middle East has been a factor in this but there is much more to the story. For starters, the plug has been pulled from the oil lake in Cushing, Oklahoma. It is a terminus for production from across the continent but until now the infrastructure to move product to refineries has been inadequate. In January, there was a record 51.9 million barrels in storage at Cushing, Bloomberg said.

That is quickly changing. The Seaway pipeline, in which Enbridge (TSX, NYSE: ENB) is a partner, has been reversed and expanded and now moves 400,000 barrels a day to Gulf Coast refineries. Work on TransCanada’s (TSX, NYSE: TRP) 485-mile Gulf Coast pipeline from Cushing to Nederland, Texas, is well advanced. It’s actually a section of Keystone that was hived off to avoid Washington’s maddening bureaucracy. It is slated to come on stream later this year with an initial capacity of 700,000 barrels a day with the potential to transport as much as 830,000 barrels daily.

As a result, there has been a much bigger drawdown in oil surpluses than analysts expected. Less supply almost automatically equates to higher prices.

Another factor in the oil price rise is the refurbishing of the BP refinery in Whiting, Indiana. It is expected to reopen later this year with 85% of its capacity devoted to heavy oil.

The role of railroad transport has also been significant in the turnaround. CN Rail (TSX: CNR, NYSE: CNI) reported that petroleum and chemicals generated $478 million in revenue in the second quarter, a gain of 18% over the same period last year. That makes the category the second-largest contributor to CN’s coffers after intermodal transport.

The tragic events at Lac-Mégantic were a grim reminder to the industry, and the country, that the opportunities presented to the railroads by the shortage of pipeline capacity also increase the dangers of major disasters. Both CN and CP have pledged to review and upgrade their safety procedures to reduce the risk of a comparable wreck on one of their lines but the possibility is always there.

Despite this, there has been no notable push-back against moving oil by rail from politicians and the public. There seems to be a general acceptance that this is a price that must be paid to keep oil (both U.S. and Canadian) moving, at least until such time as the pipeline issues are clarified.

Of course, the oil boom could reverse itself quickly if the global economy falters, thereby reducing demand. Nothing is certain. But as things stand right now, the outlook for Canada’s energy industry is certainly brighter than it was six months ago. The uncertainties are still there, but companies are coping and the prospects for improving returns are better than we’ve seen in a long time.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go here.