This year could be a "profitability sweet spot" for Canada's oil and gas sector, according to analysts at CIBC Capital Markets who see a higher-for-longer commodity price cycle outpacing cost inflation.
Rising oil and gas prices, driven by tight global supply, have padded profit margins across the energy sector in recent quarters. However, the team of CIBC analysts led by Jamie Kubik warns the cost of mining, drilling, and buying materials like steel and chemicals is set to increase, while rising taxes and royalty payments could blunt free cash flow for producers.
"We see three sources of cost inflation that investors need to be mindful of as we move into the second half of 2022 and 2023. Rising capital costs, taxes and royalties each have the potential to soften free cash flow yields," Kubik wrote in a note to clients. "The timing lag could also see 2022 as a profitability sweet spot for the sector, offering a prime opportunity for increased share repurchases and balance sheet repair."
Supported by strong profitability, Canadian energy companies have been laser-focused on returning excess cash to shareholders and paying down debt.
"While we believe we are in a higher-for-longer price cycle, producers have not meaningfully adjusted capital spending plans to drive commensurate production growth, which is unique versus prior upcycles," Kubik wrote.
In May, analysts at Scotiabank Global Equity Research predicted companies will continue to reward shareholders into 2023, as high commodity prices provide a "significant margin of safety" to keep gushing payouts.
South of the border, industry profits have become a mainstream political issue, with gasoline prices recently hitting US$5 per gallon for the first time. In a letter to oil executives on Wednesday, U.S. President Joe Biden called for "immediate action" to improve capacity as rising fuel prices drive inflation and fears of the economy slipping into a recession.
Last week, Biden accused Exxon Mobil (XOM) and its peers of capitalizing on supply shortages to maximize profits.
Borrowing from the U.K. government playbook, U.S. Senate Finance Committee chair Ron Wyden is reportedly planning to introduce legislation setting a 21 per cent surtax on oil company profits considered excessive. Last month, Yahoo Finance Canada asked industry experts how this type of policy could be imported to Canada.
When will taxes and royalties rise for oil and gas companies?
"Energy companies have carried sufficient tax pools for many years, but with profitability reaching new highs, the bulk of energy companies should become cash taxable in short order," Kubik wrote. "This calculation can scale quickly, and is likely to be a drag on consensus cash flow estimates in the near term."
"Higher prices are likely to continue to see royalty rates climb as a percentage of revenues," he added.
Jeff Lagerquist is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jefflagerquist.