We are increasing our fair value estimate for no-moat Canadian Natural Resources to $33 (CAD 42) from $28 (CAD 35), driven by increased near-term commodity price forecasts and an increase in our long-term U.S. Gulf Coast pricing for heavy oil. Trading near $26 (CAD 33), we see nearly 30% upside in the 4-star stock. We think that the market is overlooking the company’s ability to generate cash flow amid low commodity prices. While Canadian Natural is among the largest oil sands producers, not all of its production depends on the heavy oil discount, as two thirds of its bitumen production is upgraded into light synthetic oil. Additionally, Canadian Natural's portfolio spans a wide range of hydrocarbons that allow it to enjoy a corporate break-even under $35/bbl of West Texas Intermediate, including its generous dividend payment, and is the best in class among oil sands producers. However, we caution investors that we don’t expect the stock price to fully appreciate toward our estimate until oil prices recover, pipeline expansions are built, and the company increases its market access.

In addition, the stock is offering investors a 5.5% dividend yield that can be maintained with WTI prices under $35/bbl.

Canadian Natural Resources is an independent energy company engaged in upstream operations coupled with the ownership of midstream pipeline assets. The company focuses on the acquisition, development, production, marketing, and sale of crude oil, natural gas, and natural gas liquids. Canadian Natural operates in western Canada, the U.K. sector of the North Sea, and offshore Africa.

Canadian Natural's ownership of midstream pipeline assets allows it to control the transport of a significant portion of its own production and lowers its transportation expenses and overall cost structure. Thus, its cost structure compares favorably with peers. Even with a low cost structure, though, Canadian Natural faces an uphill struggle coping with lower oil prices.

Depressed realized prices due to lack of market access have forced capital spending cuts, stalling the growth potential of the company's oil sands assets. Proposed expansion projects still require high levels of capital spending, and growth is at a standstill. With growth at a standstill, Canadian Natural has shifted its focus to returning capital to shareholders in the form of dividends. Its yield of nearly 7% is at the head of the class among oil sands producers.

Canadian Natural's stock is trading in 4-star territory, and we still see upside to our fair value estimate. We think the market is overlooking the long-term ability to generate cash flow amid low Canadian commodity prices. Canadian Natural's portfolio spans a wide range of hydrocarbons that allow it to enjoy a corporate break-even under $35/barrel West Texas Intermediate, the best in class among oil sands producers. However, we caution investors that we don’t expect the stock price to fully appreciate toward our fair value estimate until oil prices recover, pipeline expansions are built, and the company increases its market access.

Moats are established by firms with durable competitive advantages that enable them to earn sustainable excess returns on capital. They are not cyclical, and severe commodity price headwinds do not preclude best-in-class operators from earning moat ratings if they can still generate significant value in the long run. The competitive advantage of exploration and production firms largely stems from the quality of their acreage. Long-run oil and gas prices are set by the marginal cost of extraction, so the ability to earn excess returns depends on the position of each firm’s assets on the appropriate cost curve, as well as the ultimate price received for the firm's production (realized selling prices can deviate from benchmarks for several reasons). Significant future resource potential is also a vital component of our moat framework because firms with limited low-cost drilling opportunities will be unable to supplant declining production without eroding their profitability.

Oil sands development projects are situated high on the crude oil production cost curve, and bitumen produced in western Canada trades at a significant discount to WTI benchmark prices. After subtracting the costs of diluent, bitumen realization differentials can range from 30% to 55% when compared with WTI. Even though upgraded synthetic oil trades in line with WTI prices, development projects require higher capital spending and cost levels than traditional bitumen oil sands projects. Accordingly, oil sands projects require higher WTI break-even prices compared with conventional oil projects. Full-cycle cash break-even prices, including dividend payments, are approximately $45 at Canadian Natural's Primrose and Kirby oil sands projects and $35 at its Horizon project (WTI). Canadian Natural's break-even prices compare very favorably with those of peers.

Although the company's cost structure benefits from its ownership in midstream pipeline assets that reduce its transportation costs and break-even prices, the reduced cost structure is not enough to offset the extensive capital required to fund growth projects. Production growth at its Kirby oil sands project requires capital spending that approximates CAD 32,000 per bbl/d of incremental production, while Horizon expansion projects capital spending approximates CAD 80,000 per bbl/d of incremental production. For the company to generate economic profit while undertaking the growth projects, sustained WTI prices would need to approximate $50/bbl WTI for the in situ projects and $55/bbl for the mining projects. Currently, we forecast long-run midcycle WTI prices at $55.

The combination of intensive capital requirements, low price realizations, and the uncertainty associated with future projects hampers Canadian Natural's ability to generate sustainable excess returns on invested capital. As such, we project that the firm will not achieve sustainable excess returns on capital within five years and conclude that it does not possess an economic moat.

Our primary valuation tool is our net asset value forecast. This bottom-up model projects cash flows from future drilling on a single project basis and aggregates across the company's inventory, discounting at the corporate weighted average cost of capital. Cash flows from current (base) production are included with decline rate assumptions. We assume oil (WTI) prices in 2020, 2021, and 2022 will average $39 per barrel, $47/bbl, and $49/bbl, respectively. In the same periods, we expect natural gas (Henry Hub) prices to average $2.10 per thousand cubic feet, $2.65/mcf, and $2.75/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $2.80/mcf natural gas).

Based on this methodology, our fair value estimate is $33 (CAD 42) per share. This corresponds to enterprise value/EBITDA multiples of 13 times and 9 times for 2020 and 2021, respectively. Our production forecast for 2020 is 1,162,000 barrels of oil equivalent per day, which represents a slight year-over-year increase. That drives 2020 EBITDA to CAD 5.6 billion. We expect cash flow per share to reach CAD 4.10 in the same period. Our 2021 estimates for production, EBITDA, and cash flow per share are 1,227,000 boe/d, CAD 8.2 billion, and CAD 6.25, respectively.

As with most integrated oil firms, a deteriorating outlook for oil and natural gas prices would pressure Canadian Natural's profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty regarding future federal tax policy.

Our capital allocation rating for Canadian Natural Resources is Standard. The company’s leverage ranks near the middle of its peer group. However, we don’t find it concerning, as we view management as acting opportunistically to make acquisitions when oil prices were low. The increased leverage can easily be offset by the company’s best-in-class cost structure, which was improved by past acquisitions.

Management has not committed to undertaking massive growth projects but instead has focused on acquiring undervalued assets to add to the portfolio. So far, this strategy has worked, as the company’s corporate break-even stands under $35/bbl, which includes its massive dividend payment. We think the dividend and future share buybacks are a good use of capital, as the stock is highly undervalued and investors can realize immediate benefits from the company’s free cash flow generation.