Editor’s Edition: Can oil & gas stocks overcome recession fears?

It’s been a nail-biting few weeks for oil and gas investors as recession fears pushed oil lower, knocking stocks from recent highs. This week, Cenovus Energy, Imperial Oil and Canadian Natural Resources are among the Canadian companies in the sector set to report financial results.

Kevin Krausert is CEO and co-founder of Avatar Innovations, a Calgary-based venture capital firm and startup accelerator that pairs entrepreneurs with the biggest companies in Canada’s energy patch. He says a mild recession today is not likely to have the same impact on the industry as previous economic contractions due to higher oil prices.

“The industry hasn’t opened the spending gates on new production and new drilling like they have in the past. You still have a fundamentally very tight supply market,” he told Yahoo Finance Canada’s Editor’s Edition. “A small amount of GDP [related] demand destruction isn’t going to lower oil prices to a level that would cause any investor too much concern.”

An analyst at Credit Suisse called for oil majors to report “one of the best quarters in terms of free-cash-flow generation.”

In this episode, Krausert also discusses the Trudeau Liberals’ preliminary plan to cap emissions from the oil and gas industry, as well as opportunities to make air travel greener.

Got a question for Kevin Krausert? Email Jeff.Lagerquist@yahoofinance.com and let him know what interests you in the world of clean energy and technology.

Jeff Lagerquist is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jefflagerquist.

Download the Yahoo Finance app, available for Apple and Android.

Video Transcript

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JEFF LAGERQUIST: Welcome to Editor's Edition. I'm Jeff Lagerquist with Yahoo Finance Canada. It's been a nail-biting few months for oil and gas investors. Today, we'll discuss what to expect when Cenovus Energy, Imperial Oil, and Canadian Natural Resources report Q2 financial results. We'll also talk about Ottawa's plans to cap energy sector emissions. And Pratt Whitney Canada says it's working on a hybrid powered regional aircraft. Test flights could begin as early as 2024.

Joining me to break it all down is Kevin Krausert. He's CEO and co-founder of Avatar Innovations. It's a venture capital firm and startup accelerator that pairs entrepreneurs with the biggest companies in Canada's energy sector. Welcome, Kevin.

KEVIN KRAUSERT: Welcome. Good morning, Jeff.

JEFF LAGERQUIST: Good morning. Some of the major players in Canada's energy sector are reporting second quarter financial results this week. We can take a quick look at the iShares TSX capped energy index here. And you can see, it's been a wild ride over the past few months. The analyst reports I've been reading call for a strong showing in Q2, even as oil prices pulled back from their $122 per barrel high in June. That's for WTI.

But as we've seen, Central banks and recession fears seem to be in the driver's seat these days when it comes to the stocks. Kevin, what do you expect to hear from the executives when they get on the conference calls? Will they address this recession fear that seems to be on everybody's mind?

KEVIN KRAUSERT: Yeah, certainly. The recessionary fears are probably the largest material risk to energy prices. And so I would expect the entire sector would address recessionary risk in a meaningful way. But the reality is from an energy perspective, a mild recession this time around, will likely have much less of an impact on commodity prices, which is driving the stock valuations of most of these companies less than it has in years past, because the industry hasn't opened the spending gates on new production and new drilling like they have in the past.

So you still have a fundamentally very tight supply market. So even if you see a little bit of demand destruction, I still see oil prices staying strong, especially with the geopolitical fears and risks that are happening. So yes, it will be meaningfully addressed. But I don't think it'll have as much of an impact on energy as a mild recession has in the past.

Now, a catastrophic scenario, which I don't think anyone's predicting, would have a major impact. But the reality is that the fundamentals of the market remain really tight. And so as a result, a small amount of GDP demand destruction is I don't think going to lower oil prices to a level that would cause any investor too much concern.

JEFF LAGERQUIST: To your point, we've seen results from some of the big service names, like Schlumberger, Baker Hughes, and Halliburton. I think with the exception of Baker Hughes, they've been pretty strong quarters. Halliburton, I believe they said, all of their equipment is I believe, they said it's sold out or occupied or spoken for, for the entire North American market. So that's got to be a good thing.

But when we look at the US Federal Reserve, which we'll be hearing from tomorrow, how much do you think that will determine the path forward for energy stocks and just sort of general sentiment around fuel demand?

KEVIN KRAUSERT: You know, I don't think not as much as recessionary risk. The last year, since commodity prices have been strong, most of these companies have been very busy, busily paying down debt. And there's also not a whole lot of major capital projects being contemplated right now, other than sort of the emissions reduction projects.

So sentiment around increasing interest rates certainly increases the cost of capital on existing debt. But because so much of the debt has been paid down by industry recently, I wouldn't say it's going to have as material of an impact as commodity prices necessarily would.

Now obviously, that's sort of watching you know, the whole health of the economy. But I would say the Fed, from an industry-- energy industry perspective, would be secondary to recessionary risk. You're only looking at it through the, does the Fed overreact to cool the economy down, basically inducing a recession, to get inflation under control? That would be the number I would looking at. But half a basis point here, I don't see it as having a material impact on the industry given its current state.

JEFF LAGERQUIST: Given the sort of uncertain footing of the global economy these days, what do you think companies are going to do with this extra cash that they find on their balance sheets? To your point, they have been socking that away for a long time, rather than investing in new production.

A note from Credit Suisse says Cenovus could announce a special dividend on their Q2 call, which is coming up this week. And one of their analysts also predicts Canadian Natural Resources could add to its oil and gas portfolio. And I believe that that means an acquisition. What do you-- what do you think? Where does the cash go?

KEVIN KRAUSERT: Yeah, you know, I'd say they continue to pay down debt, buy back shares, and return cash flow to shareholders through dividends or special dividends, given their strong position. You know, if the industry is basically going to turn into this highly efficient machine that is designed around one thing and one thing only, and that's delivering value to shareholders, because the stocks are undervalued, I'd say the way they're going to be returning their shareholders is through the mechanisms I just talked about.

And potentially, acquisitions make a lot more sense than new drilling right now in the sense that, how can you consolidate your portfolio around your strong acids and maximize value? I see that as being the name of the game. Most of the small and intermediate producers, their-- their debt reductions plans are going to have them nearing debt free next year. And the large caps, I think they're going to continue their trend of focusing on their core assets. So you know, it's a cash flow machine is-- is I see where the industry is going.

JEFF LAGERQUIST: When we look at potential headwinds on the horizon in that Credit Suisse note, they briefly mentioned monkeypox as a potential headwind for oil prices. The World Health Organization declared it a public health emergency yesterday. Could that have an impact? I really don't know too much about monkeypox.

KEVIN KRAUSERT: I think the world collectively decided after the last pandemic they weren't ready for another one. You know, but brevity aside, you know, there's I think, always going to be these sort of headwinds and disruptive risks that are always around the corner that we're in an era of increasing volatility. And so what industry is doing, and should be doing, is embedding resilience into their strategy such they can handle these types of bumps in the road.

But I'd say after the experience of the last pandemic, I think the collective psyche of the planet, it would take a pretty serious public health to drive us back to anywhere where we were in the last pandemic.

JEFF LAGERQUIST: Yeah, I guess we'd have to sort of see those restrictions on travel, work-from-home policies for big corporations, that kind of thing that would keep people from filling up their cars. Well, I guess that's sort of yet to be seen. Let's move on from earnings to regulations.

Canadians got their first glimpse of how the Trudeau government plans to implement the oil and gas emissions cap they promised in the last election. Ottawa wants to cut emissions across all sectors by 40% to 45% from 2005 levels by 2030. That would mean bringing the oil and gas sector down to a level last seen in 1992.

Now, obviously, the sector has grown substantially since then. And at the same time, we've seen you know, gains in terms of per barrel emissions and stuff like that. Not gains, reductions-- but gains in terms of progress on that issue. The government discussion paper released a few weeks ago proposes either a new cap and trade system for the sector or adjusting the carbon price that companies pay.

Before we unpack those two options, maybe we should take a little bit of a look at a chart from the government discussion paper. As you can see, the oil and gas emissions are pretty close in size to transportation. So sort of given that, does it make sense to treat one source differently than others and implement a sector-specific approach for oil and gas?

KEVIN KRAUSERT: You know, industry and the federal government have certainly come a long way in the past few years. And I'd say there's pretty strong alignment between the two on how we deliver a net zero 2050. Nearly every Canadian major has committed to net zero by 2050. And I think the oil and gas industry is-- is uniquely motivated and uniquely positioned to actually deliver those emissions reductions.

In terms of a sector-specific plan, if the oil and gas industry can actually deliver its net zero goals, I think there's a lot of ancillary benefits for sectors that are outside of it. You know, Canada has some of the most blessed geology in the world for actually capturing and storing carbon. So just as it was in years past where you had heavy industry conglomerate around resources, like rivers with the water wheel, I think Canada is uniquely positioned to build out a carbon capture infrastructure with its suitable geology and actually attract other sectors from it-- growth from it.

So if the government wants to take an approach of, how do we incentivize industry to invest in these technologies in a collaborative manner, I think that would be well received. If it is going to go down a road of bludgeoning an industry with a hammer, I don't think that would be well received, because it won't result in either emissions reduction and frankly, probably just results in capital leaving the country again.

We're in a good spot to move forward, and discussion paper definitely got a lot of attention last week. But you know, I think many of us have been relieved to hear some of the clarifications coming out of the federal government since.

JEFF LAGERQUIST: Has there been an outsized focus on the oil and gas sector? I mean, sort of given the rest of all of the other things in that pie, I mean, I think that we're-- a sector-specific policy solution would only focus on 25% of overall emissions if it was applied to just oil and gas.

KEVIN KRAUSERT: I think you know, before we totally go into the drill into this, I think it's certainly worth noting that the Oil Sands Pathways to Net Zero Alliance, which is an alliance of all of the-- basically all of the Oil Sands producers have proposed a detailed and costed plan for about a 22 megaton emissions reduction by 2030.

Why I think the policy paper got a lot of attention last week was, they proposed two options. And it didn't initially sound like there was going to be a lot of flex in it. Their option A was a cap and trade system for just oil and gas. While option B would be an industry-specific carbon tax.

So if the goal is to incentivize industry to invest in emissions reductions while promoting economic growth, both of those options fall short. The first, an oil and gas-specific cap and trade system would actually derail many of the carbon offset mechanisms that are finally starting to get traction. There are numerous ways to offset carbon using agricultural or nature-based solutions that can offset those. And so if you were to ring fence the oil and gas industry from agriculture, for example, I can't think of a single farmer that would be supportive of that mechanism. We need to be looking at the broad context.

The second option that was proposed, an increased carbon tax you know would-- to somewhere in the neighborhood of $300 a ton for oil and gas-- that would derail the economics of production. So the unintended effect is that producers would choose to shut in production instead of investing in the emissions reduction technologies that can actually deliver it.

So using the Oil and Sands Pathways Alliance example, which I think is a nation-building project, basically what investors are looking for is regulatory uncertainty. The federal government announced an investment tax credit in carbon capture measures in the most recent federal budget. That was a really good start.

But what is needed to get these projects actually shovels in the ground is some sort of guarantee that these pricing incentives are going to last. And so I think what's actually needed is some sort of contract for differences. How can you provide the investors who are going to invest in these technologies? They're not going to do it out of the goodness of their heart. They're only going to do to generate a return.

And so the government needs to provide some sort of regulatory certainty, which is the sort of contract for differences. So as I mentioned, when the federal minister of the environment clarified his intentions this weekend that there was negotiating room, I think that was a really positive step forward. But the reality is too, we're talking about building major industrial carbon capture projects and nuclear projects that-- and Canada has a really troubling track record of regulatory approval for major projects.

So here on the one hand, you've got the feds saying, OK, reduce emissions by 40% in 7 and 1/2 years. But it takes six years to get a permit to build something major. Germany recently came out and you know, basically said their regulatory approval process for major energy projects-- they were going to shorten to one year given the light of energy security.

If Canada wants to win this, we can't just have a conversation around how to incentivize them. We have to have a conversation around the competitiveness and regulatory certainty, regulatory approval timelines for us to get there. And on that issue, there's a lot of alignment between industry and the federal government.

JEFF LAGERQUIST: But which direction do you think the industry is leading-- leaning between cap and trade or modified carbon price?

KEVIN KRAUSERT: You know, I think we'll see where the industry goes. I think the industry needs a contract for difference is what they need. They need certainty that they're going to be going there. I don't think either are helpful. I think there's unintended consequences of both options.

And the conversation that we need to be having is, how do we incentivize certainty to the investors so they invest in these technologies to not just ensure the longevity of Canada's primary economic engine in a carbon constrained world, but also open up the door to many other heavy, heavy industries that can be structured around Canada's carbon-- carbon capture solution? So I would hope conversations evolve past the two options proposed in the discussion paper.

JEFF LAGERQUIST: So the provinces have jurisdiction over natural resources. That's a point raised recently by Alberta Energy minister Sonya Savage. But the Supreme Court has ruled that Ottawa has jurisdiction over emissions. If this policy, whichever direction they go, modified carbon price or cap and trade, if it actually starts to impact like levels of investment and levels of production, has the federal government crossed a boundary there? I think the Pathways Alliance has said it's concerned that the government's approach, as it's written now, could lead to shut-in production?

KEVIN KRAUSERT: Yeah, and I think that Minister [INAUDIBLE] clarifications over the weekend have calmed a number of people down in this industry that there is-- that there's room for negotiation. But you know, it is-- you know, as I've explained in the past, this is a three-party issue. This is the government of Canada, this is the province of Alberta, and this is the investors of the company, who have first of all, international investment opportunities, so that if they think they can generate a better return somewhere else outside of the country, that's where they're going to go.

The province has a huge role to play in this, and as well as the federal government, who's made these commitments on emissions reductions. So I would hope all three of those parties are working closely together to deliver that-- that result.

JEFF LAGERQUIST: So to your point about regulatory uncertainty, there are a lot of unanswered questions with respect to this discussion paper, like the actual-- what the actual emissions level will be and the scope of all of this. Do you expect that petroleum refining and natural gas transmission lines will fall under a you know, government-- whatever the government decides to do here?

KEVIN KRAUSERT: Well, yeah, in terms of how they want to parse out what they define is as oil and gas. But it's going to be every sector, every industry that is on-- has to commit to these emissions reduction targets if we're going to get there. So whether they include downstream and midstream in that same plan, there's a very connected value chain. But in terms of the exact mechanism-- policy mechanism they want to incentivize this, I think that's yet to be determined.

JEFF LAGERQUIST: If refineries, for example, were included, could you see some producers maybe shutting down refineries in Ontario and Quebec in order to lower their footprint for their core businesses in Alberta?

KEVIN KRAUSERT: I think that would be an unintended consequence. That was the period of the divestment movement, right, where the divestment movement, which is basically an abject failure, was telling companies to sort of divest of their low-emitting assets-- or their high-emitting assets and concentrate on their low-emitting assets. But what that-- the unintended effect of that was basically, just put some of these high-emitting assets into companies and investors that are less concerned about ESG and reducing emissions.

So even you're hearing from Mark Carney and the Glasgow Financial Alliance is, how can you actually create a structure where you can incentivize investors to actually increase the current carbon in their portfolio, so long as those companies have credible, meaningful plans to reduce those emissions? And that's how you're going to make the biggest impact on reducing emissions is not just by you know sending high-emitting assets over to investors that don't care about emissions reductions. It's actually incentivizing or rewarding the companies, like Suncor and Cenovus, who are busily reducing emissions and have credible meaningful plans to get there.

JEFF LAGERQUIST: If we lost some refining capacity in Canada and relied more on imported gasoline, diesel, jet fuel, all of that, would that leave us a lot more exposed to sort of swings in price?

KEVIN KRAUSERT: Well, I think it speaks to the energy security issue, right, that right now, we're just seeing the you know, Germany have a major wake-up call on its failed energy strategy over the past decade. Canada does not want to go down that road. And importing energy when we are basically-- we're the fourth largest energy exporter in the world, you know, that's-- that would be-- that would be a major misstep from future economic prosperity perspective.

JEFF LAGERQUIST: OK, for our final topic today, I want to talk about the aviation industry. Obviously, this is a major source of emissions and a tough sector to decarbonize. That's why Pratt and Whitney Canada is partnering with a major engineering firm to advance its Hybrid Electric Regional Aircraft program.

As I said at the top of the show, test flights could begin as early as 2024. Kevin, do you think this sort of hybrid, short-distance propeller aircraft is a logical entry point for reducing emissions in aviation?

KEVIN KRAUSERT: Well, I'm certainly not a aviation industry expert, but I am an energy expert. But I do really like airplanes, maybe not airports so much lately, but-- so I really hope there's net zero 2050 aviation options. You know, and it's probably worth disclosing, Avatar has a partnership with AEI HorizonX, which is Boeing's venture capital fund that invests in many of these types of technologies.

The reality is. It's actually really difficult to electrify commercial aircraft for long distances. And that's because of basic energy density. The amount of energy that can be stored at a battery versus the weight versus the amount of energy that can be stored in jet fuel versus the weight to kind of get it off the ground-- try getting a 747 off the ground with batteries. And so they're looking at you know, I'd say there's-- there's three or four technology routes that could be explored in sustainable aviation.

The first is obviously electrification. That's really going to be for short distances. And so, yeah, that's a potential-- a potential solution. But also, the reality is, is we've actually had net zero airplanes for almost a decade. It's using a technology called sustainable aviation fuels. So that's using biofeedstocks, biomatter, to go through some sort of chemical process where we can create a hydrocarbon.

And so because we took the carbon out of the atmosphere in the plants and then put it into a fuel, results in a net zero solution. The challenge is, even though we have sustainable aviation fuels and there's been somewhere in the neighborhood like 100,000 flights already flown on this, it's ridiculously expensive. It's a magnitude more expensive more than current solutions.

So what we're going to need is some sort of breakthrough in the cost of those types of solutions. Lanza Jet, which is a Canadian-based sustainable aviation fuel company out of Montreal, working on some really, really cool technologies. But you know, I see it going down that road.

You know, Airbus has made a lot of positive news and hype around hydrogen. Hydrogen, as an option, is certainly viable if the fuel cell technology was proven safe. There still is the energy density issue. Hydrogen is nowhere near as energy dense as jet fuel. So you'd have to be looking at those types of solutions.

But from my view, I think sustainable aviation fuels is probably going to come up the winner. But it's still going to require some breakthrough technologies to bring costs in line.

JEFF LAGERQUIST: Yeah, absolutely. I think that there is some really interesting stuff being done on the fuel and actually, like using algae and all sorts of things to produce new variants of fuel. And Rolls Royce I think, is working on a hydrogen jet engine. So it'll actually be interesting to see how all of this shakes out.

At the same time, some of the major carriers, including Air Canada, are exploring carbon capture as a means to shrink their carbon footprint. Is that the right technology for the job? Obviously, we're not talking about capturing the carbon out of the air as the plane is flying by. You know, I suppose these would be installations at airports and other places like that. Do you think that could work?

KEVIN KRAUSERT: Well, I think what specifically what they're looking at is direct air capture, so that's pulling CO2 out of the atmosphere. And there is technologies that can do so. There's two major global companies, one of which is Canadian, Carbon Engineering, that can do this at scale.

And Elon Musk just you know, put $100 million into incentivizing direct air capture processes through his XPRIZE. You know, right now, it is far more expensive. You're basically fighting thermodynamics with direct air capture. We're going to combust CO2, put it in the atmosphere, and then pull it out later.

Basic thermodynamics suggest that that's a difficult way. But if you could get the cost of direct air capture down to a point that it was more competitive than some of these sustainable aviation fuels or hydrogen solutions, then you would have a panacea. As opposed to sitting, white knuckled in a hydrogen airplane for the first, you could just run it and pull the CO2 out.

But while the numbers I've seen on direct air capture, they vary widely. And so you'd need a big breakthrough in the technology to bring the costs in line. But if you could, yeah, it would be-- it would be a bit of a panacea for the airline industry status quo.

JEFF LAGERQUIST: All right, just lastly, I want to touch on the fanciest end of the aviation business. That would be private Jets. Drake is facing some backlash for multiple flights between Toronto and Hamilton in this Boeing 767. It's a 70-kilometer trip that burns nearly $3,000 worth of fuel in 18 minutes according to a flight tracking website.

Kevin, I obviously have a lot in common with Drake. But I had to take a car from Toronto to Hamilton today with my girlfriend. Do you think eventually the criticism over the emissions will one day put a stop to like the jet-setting celebrities and business executives? There's so much we can do from home these days, as we've learned throughout the pandemic. But when you look at companies like Bombardier, private business jet demand is booming. So what happens?

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KEVIN KRAUSERT: I think that potentially, this is going to be a policy area. Without commenting on Drake's personal travel patterns, you know, you have seen jurisdictions such as France sort of come out and say they are going to ban short-haul flights less than two hours if there's an alternate rail route that is on the way. You know, where does this go? You know, I don't-- I don't know.

But I have a hard time imagining this is going to impact Drake's record sales too much. So I think it's gonna be, how do the markets-- how do the markets evolve? And where do individuals feel like they're getting the best value for the dollar? And what are the public policy mechanisms that are going to impact these types of decisions?

JEFF LAGERQUIST: Well, it's an interesting conversation about the private jets that I often have with my father, who well, supported our family by flying business jets, Canadian executives all over the place to their various meetings all around the world. So yeah, it will be interesting to see where that kind of business goes. Kevin, I think that's a good place to end for today. Thank you so much for joining me.

KEVIN KRAUSERT: Awesome. Thanks so much, Jeff.

JEFF LAGERQUIST: For all the latest news on clean energy and the broader world of Canadian finance, please visit the Yahoo Finance Canada website. I'm Jeff Lagerquist. See you next time.

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