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8-Year High: Can MEG Energy Stock Keep the Momentum Going?

oil and natural gas
Image source: Getty Images

Written by Vineet Kulkarni at The Motley Fool Canada

Almost all Canadian upstream energy producers saw record financial growth last year. How the growth plays out and how much of that cash is allocated to shareholder returns are key drivers for TSX energy stocks this year.

MEG Energy to report Q1 earnings on May 1

Among the star performers, MEG Energy (TSX:MEG) saw its free cash flows jump five-fold last year against 2021. Such a steep jump created massive shareholder value, and the stock has returned almost 1,400% since the pandemic. It is all set to report its first-quarter (Q1) earnings on May 1. It will be interesting to see whether its upcoming numbers fuel the stock further higher.

MEG Energy aims to produce around 105,000 barrels of oil equivalent per day in 2023 on a capital expenditure of $450 million. It has low-cost bitumen wells in the Christina Lake project located in the southern Athabasca region. It has a total 2P (proved plus probable) reserves of two billion barrels, representing a reserve life index of over five decades. That is some of the largest reserve life index (RLI) in the Canadian energy space. The RLI is simply an indication of how many years a company would take to exhaust its reserves going at a current production rate.

MEG does not own refineries like its peer bigwigs, which makes it more susceptible to the Western Canadian Select (WCS) differential. It is the Canadian benchmark for heavy oil that trades at a significant discount to West Texas Intermediate (WTI) oil. As the discount widened last year, it negatively impacted MEG’s cash flows to some extent.

Financial growth and balance sheet  

Thanks to its rapid free cash flow growth last year, MEG Energy repaid $1.3 billion of debt last year. It currently sits at $1.3 billion net debt, taking its leverage ratio to 0.8. That’s a noteworthy improvement from its leverage of around five in 2020. MEG used to have a heavy debt burden on its balance sheet a few years back. However, this capital discipline and balance sheet strengthening has made it quite investment worthy.

MEG is currently allocating 50% of its free cash flows to shareholder returns, mainly buybacks. It aggressively bought back millions of shares last year. It makes sense to prefer share repurchases over dividends as the prior offers more flexibility to the management. As the total number of outstanding shares falls, the company’s per-share earnings grow, making existing shares more valuable. Plus, the buybacks push the share price up in the short term.

Interestingly, MEG considers allocating 100% of its free cash flows to shareholder returns once its net debt falls below $800 million. The management also aims to introduce a base dividend then.

Valuation and conclusion

Even if oil prices have dropped from last year’s highs, they are still higher by historical standards. According to MEG’s guidance, it expects to generate a decent $700 million in free cash flows at current oil prices. That’s a handsome 15% yield.

On the valuation front, MEG stock is trading six times its 2023 free cash flows — a discount against the industry average of seven times. Higher production in the strong price environment will likely drive superior free cash flow growth for MEG. Its improving balance sheet and growth visibility make it stand tall in the industry. Moreover, a WCS-WTI differential tapering could be a big growth driver for MEG stock later this year.

The post 8-Year High: Can MEG Energy Stock Keep the Momentum Going? appeared first on The Motley Fool Canada.

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The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.  Fool contributor Vineet Kulkarni has no position in any of the stocks mentioned.