Why I don't own MEG Energy

And why Bay Street thinks you should

In most respects, MEG Energy (MEG.TO) is similar to a power utility - it produces energy and sells that energy at market prices. Sure the energy it produces is a heavy oil variant called Alberta Western Blend (AWB) and is sold to refiners but it is nonetheless energy. And MEG is not an exploration company, it is exploiting the reserves on its acreage which should last 35 or 40 years. In the past decade and until very recently, MEG has paid no dividends, which distinguishes it from most “utilities”. Most utilities have permanent assets they can maintain and use for many years to come. MEG’s infrastructure has value only as long as its reserves last.

Oil & gas investors have taken to valuations of oil & gas companies using various metrics tied to earnings before interest, taxes and depreciation and amortization (“EBITDA”) or cash flow, which is appropriate for exploration & development companies (“E&P’s) since they can and must use their cash flow to maintain output and can distribute any surplus cash flow to shareholders as dividends or use it to explore for and exploit additional reserves. Some use their surplus cash flow to buy back stock, in my opinion a useless endeavor that benefits short term stock prices and management options, but divides shareholders into camps and can never produce a greater return than the company’s return on equity but if poorly timed can produce a lot less.

The typical oil & gas company has no bounds to its future growth other than its ability to finance that growth. A typical multiple of EBITDA used to value an E&P company is between 4 and 6 times, depending on their organic growth rates and operating economics.

Those characteristics don’t really apply to MEG Energy, at least not on the strategy the company has followed since going public, which is to develop its existing reserves using steam assist gravity drainage (“SAGD”) technology with little other activity and virtually no exploration or expansion outside of its historic footprint. In my opinion, likely a controversial opinion, MEG should be thought of as a typical energy utility, measured on net income after tax and valued using multiples of earnings rather than multiples of EBITDA or cash flow as the primary metric. Of course, MEG has an added feature in that the value of its reserves will increase or fall with the prevailing price of AWB and the present value of its future cash flows available to shareholders will be determined by the AWB price by and large, operating costs being well controlled by a competent group of managers. To that extent, MEG’s reserves can be valued as a call option on future commodity prices, similar to other resource companies.

Think of MEG like a electricity utility selling power to the grid subject to the prevailing price of power in an unregulated market. Alberta is the only Province to have fully deregulated electricity and natural gas markets, and MEG is the beneficiary or victim of that marketplace.

Looking back over the last decade, MEG has operated at a cumulative loss using International Financial Reporting Standard (“IFRS”) accounting, as set out in this chart, with an average after tax return on equity of -7.8% over the last decade. Income and equity entries are in millions of dollars.

In January of 2014, MEG shares traded at just over CDN$30 a share. They trade at about CDN$25 a share today.

MEG has about 268 million shares outstanding and at today’s trading price of CDN$25 has a market capitalization of CDN$6.7 billion. I think the most comparable utlility, if you buy my argument that MEG is more like a utility than an E&P, an appropriate Price to Earnings (PE) multiple is about 10 times. Capital Power pays a 5.4% dividend and has a PE ratio of 9.55 times. MEG’s average net income for the past three years is CDN$584 million. At a PE of 10, MEG’s shares are worth CDN$22 a share. A somewhat comparable oil producer is Imperial Oil (IMO) which trades at at PE multiple of 9.6 times.

So why does Bay Street think it is going much higher (average “target prices” are in the CDN$35 per share range)? Primarily because Bay Street analysts job is to promote trading so the intermediaries that employ them earn trading fees and commissions, and it is easier to persuade retail investors to buy than to sell shares.

In my opinion, oil investors are virtually always bullish on the price of oil and the potential for trading gains on a well capitalized E&P, and they may be right that MEG shares might appreciate in trading price if oil prices remain firm or rise. MEG now pays a tiny dividend, has a buyback program (which retail investors seem to like) and bets on MEG may pay off for some investors. MEG has been a favorite of energy traders for at least the past decade and it is plain and obvious that traders as a group have lost money while brokerage firms and brokers have made money promoting those trades.

I wouldn’t touch MEG at today’s trading price of CDN$25 a share. Despite MEG’s 30 odd year reserve life (which may rise with additional drilling) MEG is selling off 2-3% of its reserves every year and when the dust settles, what will be left over for shareholders is cumulative net income. The 17% decline in trading price over the past decade seems to parallel the decline in reserves resulting from a portion of reserves being developed and sold each year.

Oil seems in over supply for the time being, the world economy keeps teetering on the edge of recession, and there are better oil names for long term investors than MEG. Canadian Natural Resources (CNQ), Exxon subsidiary Imperial Oil, Suncor (SU), Cenovus (CVE), and Chevron have long reserve lives, clean balance sheets, and will be around a lot longer than 35 years. These are (in my opinion) better choices than MEG.