Setting the stage for what may be a sequel of sorts to the now-epic drama over the construction of the Keystone XL extension to the existing Keystone Pipeline System, TransCanada Corp (TSX: TRP, NYSE: TRP) announced this week that it would like to proceed with a plan to build the Energy East Pipeline, which would connect Alberta’s oil fields to export terminals and refineries on the Atlantic Coast.

The much-discussed Keystone XL, the lower, US-only portion of which is already under construction, would convey heavy crude to refineries in the US Midwest and along the Gulf Coast, solving a supply glut and helping bring Canadian crude price in line with West Texas Intermediate and European Brent for the long term.

In the words of one environmentalist active in anti-Keystone XL demonstrations, this is not a game of “whack-a-mole”: Equal energy will be spent opposing Energy East, on the grounds that delaying for as long as possible these infrastructure projects increases the likelihood that the fossil fuels they’re designed to carry will remain, of course, on the ground.

But reality is a cruel friend, particularly to environmentalists. As a recent report from the Woodrow Wilson International Center for Scholars notes, “We cannot snap our fingers and be off hydrocarbons tomorrow, nor can we snap our fingers and move instantly to renewable sources of energy.”

Reasonable minds that have trained on the problem are in basic agreement that we’ll need oil for the next half-century. Accepting this as fact does not obviate the twin needs to diversify our energy sources and to make production and transportation of existing fuels more efficient in terms of greenhouse-gas emissions.

At the same time we build out the infrastructure necessary to facilitate the export of North American oil and gas to foreign markets currently experiencing rapid levels of fuel-consumption growth, we can also export the technologies that will help those economies mature in an efficient, environmentally friendly way.

But first things first: The key to unlocking North America’s–and Canada’s–energy potential is infrastructure.

Rail and Pipe

Prices on global crude markets diverged sharply in beginning in mid-2012 through 2013, as European Brent surged to a USD20 premium over West Texas Intermediate (WTI) and a more than USD40 premium to Western Canada Select (WCS).

Transportation bottlenecks between new US and Western Canadian supply regions and refineries in the US Midwest and the Gulf Coast helped create these differentials.

Differentials have recently narrowed but likely due to short-term factors. More transportation will be needed as US unconventional oil resources continue to expand and output from the Canadian oil sands continues to grow.

Pipeline projects such as the Seaway reversal helped move crude more efficiently to refining centers, and the increasing use of crude-by-rail transport has also contributed.

The deepest penetration of railroads as a transporter of crude oil has been in the Bakken Shale in North Dakota, Montana and Saskatchewan. Rail transportation of crude and bitumen has also emerged in the Western Canada oil sands.

Southern Pacific Resources Corp signed a deal to transport its entire bitumen production via Canadian National Railway Co (TSX: CNR, NYSE: CNI), and MEG Energy Corp (TSX: MEG, OTC: MEGEF) is building a terminal that will allow transportation of its 32,000 barrel per day production of Canadian bitumen production by pipeline, rail and barge.

Rail shipments of crude oil from Western Canada are 120,000 barrels per day, and rail loading capacity is expected to grow to 200,000 barrels per day by the end of 2013. Costs of moving crude by rail compared to moving it by pipeline are also converging. But capacity to meet growing output is still lacking.

Canadian National is more bullish on crude-by-rail than its main competitor, Canadian Pacific Railway Ltd (TSX: CP, NYSE: CP). Both have benefitted from the early trend, though their stock prices certainly reflect this and much more.

CN Rail and CP Rail are holds at these levels. 

MEG Energy, on the verge of significant production growth with the advancement of development at its Christina Lake oil sands project, is a buy under USD32.

The Montreal, Maine & Atlantic Railway filed for bankruptcy this week, noting that this course for its Canadian and US units was “the best way to ensure fairness of treatment to all” in the aftermath of a “tragic” crude oil train derailment in Quebec.

The July accident, which occurred when a parked train of crude oil tank cars ran away, derailed and exploded in the town of Lac-Mégantic, killed at least 42 people and left a further five missing, presumed dead. The disaster was one of the worst-ever on a North American railroad not involving a passenger train.

The incident has led to a thorough review of the safety of the fast-growing market for moving crude oil by rail. And it highlights the continuing importance of pipeline infrastructure.

TransCanada is now proposing a CAD12 billion project that will move as much as 1.1 million barrels a day from the oil sands in Alberta to New Brunswick by 2018.

The 4,400 kilometer (2,734 mile) Energy East line would need support from provincial governments in Alberta, Saskatchewan, Manitoba, Ontario, Quebec and New Brunswick.

Demand for the line is firmly in place, as TransCanada has 900,000 barrels of oil a day in long-term contracts from producers in Western Canada.

Cenovus Energy Inc (TSX: CVE, NYSE: CVE), the fourth-largest Canadian oil producer, expects to ship 200,000 barrels a day, some of which may be exported overseas. And Suncor Energy Inc (TSX: SU, NYSE: SU), Canada’s biggest oil producer, is “actively engaged” in the new pipeline.

Cenovus is a buy under USD40. Suncor, which recently boosted its dividend by more than 50 percent, is a buy under USD33.

In addition to its controversial Keystone XL and Energy East proposals, TransCanada owns or has interests in approximately 42,000 miles of natural gas pipelines that move approximately 14 billion cubic feet a day, or about 20 percent of North American demand.

It also has about 400 billion cubic feet of natural gas storage capacity and 21 power plants with a total generating capacity of nearly 12,000 megawatts.

TransCanada has announced a dividend increase along with first-quarter results every year since 2004. During this time the quarterly payout has grown from CAD0.27 per share to CAD0.46.

TransCanada is a solid buy under USD47.

Pembina Pipeline Corp (TSX: PPL, NYSE: PBA), which acquired Provident Energy Ltd in January 2012 to become one of Canada’s largest publicly traded energy infrastructure companies, is well situated to grow along with Canadian oil sands output.

In June 2013 the company signed an Engineering Support Agreement (ESA) with KKD Oil Sands Partnership (KOSP) covering the Cornerstone Oil Sands Pipeline project in Alberta.

KOSP is a partnership between Norwegian state-owned entity Statoil ASA (Norway: STL, NYSE: STO) and PTT Public Company Ltd (Thailand: PTT, OTC: PETFF), a Thai state-owned oil and gas company.

The Cornerstone Pipeline would transport diluent and blended bitumen between KOSP’s upstream developments and the Edmonton area, including diluent connectivity at Pembina’s Nexus Terminal.

Pembina and KOSP will spend up to approximately CAD35 million to conduct preliminary engineering work and begin associated stakeholder consultations.

Pembina already transports crude oil from Fort McMurray-based Syncrude Canada Ltd, which trades publicly as Canadian Oil Sands Ltd (TSX: COS, OTC: COSWF) and Canadian Natural Resources Ltd (TSX: CNQ, NYSE: CNQ)  to markets near Edmonton.

Pembina also provides infrastructure support to oil sands producers located southwest of Fort McMurray. It has approximately nearly 1 million barrels per day of fully contracted oil sands crude oil transportation capacity.

Pembina’s oil sands assets–the Syncrude Pipeline, Cheecham Lateral and Horizon Pipeline– operate under long-term, extendible contracts that provide for the flow through of operating costs to shippers. Operating income generated by these assets is related to invested capital and isn’t sensitive to fluctuations in costs or capacity utilization.

Pembina Pipeline is a strong buy on dips to USD30.

Long-Term Value

In early 2013 the Canadian energy industry was under intense pressure due to fears of a “bitumen bubble,” a price-killing glut of oil sands-derived crude caused by insufficient export pipeline capacity.

That’s evolved, as these things often do, into a “bitumen bounty.” Overall supply has lagged expectations, new demand is coming from a major US Midwest refinery and railways have been carting away increasing volumes of crude, easing pipeline congestion.

In mid-July Western Canada Select (WCS) heavy crude sold for more than USD90 a barrel for the first time in about 10 months, up from lows around USD50 in January. That’s helped share prices of Canadian producers rebound, with the S&P/Toronto Stock Exchange Capped Energy Index rallying by nearly 10 percent.

Vermilion Energy Inc (TSX: VET, OTC: VEMTF) is immune to the problems of WCS and WTI crude pricing. This Canada-based producer with significant assets overseas enjoys the benefits of higher Brent pricing for its output. There is no issue of “price differentials” with Vermilion.

Vermilion recorded the strongest operating quarter in its history in the second quarter of 2013, due to the success of its capital program. Average production of 42,813 barrels of oil equivalent per day (boe/d), up from 38,707 boe/d in the first quarter and 39,168 boe/d in the second quarter of 2012, resulted primarily from strong production additions from its Cardium and Mannville drilling in Canada and high productivity from its two-well sidetrack program in Australia.

Management had previously increased production guidance following the first quarter of 2013. Following its recent results Vermillion now expects production for 2013 to between 40,500 and 41,000 boe/d, up from previous guidance of 39,500 to 40,500 boe/d and original guidance of 39,000 to 40,500 boe/d.

Vermilion reported funds from operations of USD174.6 million, or USD1.73 per share, in the second quarter, up 7 percent sequentially from USD163.6 million, or USD1.65 per share, in the first quarter of 2013 and up 37 percent year over year from USD127.8 million, or USD1.30 per share.

Vermilion’s Brent-based crude production, representing 41 percent of total production, averaged USD105.25 per barrel in the quarter. WTI crude, representing 25 percent of production, averaged UsD94.22 per barrel.

Vermilion’s natural gas production in the Netherlands, representing approximately 15 percent of production, received an average price of USD10.82 per thousand cubic feet (mcf), a premium of USD7.29 per mcf as compared to AECO.

Vermilion, a July Best Buy, is a buy on dips to USD52.

A Word on Gas

CE Portfolio Aggressive Holdings ARC Resources Ltd (TSX: ARX, OTC: AETUF) and Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) have both sold off in recent weeks due to the renewed deterioration of natural gas prices from recent highs.

But both are poised to build wealth for investors over the long term, as evidenced by ARC through its ambitious 2014 production ramp-up, by Peyto through its industry-leading–and frankly astounding–extremely low-cost production profile.

ARC reported second-quarter production of 93,436 boe/d, consistent with 2012 levels. Second-quarter crude oil and liquids production of 36,644 barrels per day increased slightly. Higher 2013 liquids production is the result of ARC’s focus on opportunities that generate the highest rates of return and cash flows.

Commodity sales revenue was up 27 percent to CAD403.4 million due to higher realized crude oil and natural gas prices. Crude oil and liquids production contributed approximately 70 percent of second-quarter revenue due to the strength of crude prices relative to natural gas prices, despite accounting for 39 percent of production.

Funds from operations were CAD201.2 million, or CAD0.65 per share, up 21 percent year over year primarily due to higher crude oil and natural gas prices in 2013.

ARC’s execution of its 2013 budget remains on track to meet full-year 2013 production guidance of between 93,000 and 97,000 boe/d , and sets the stage for average production in excess of 110,000 boe per day in 2014 with the completion of the Parkland/Tower gas processing and liquids handling facility.

ARC Resources is a strong buy under USD26.

Peyto will report any day now but as a general matter doesn’t announce its earnings reporting date ahead of time.

The lowest-cost producer in the space, with the capability of turning a profit with commodity prices below even USD2, Peyto is a buy up to USD33.

Aggressive Speculation

Former CE Portfolio Aggressive Holding Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) is trading at a significant discount to the value of its in-the-ground assets, with a price-to-book value of just 0.68 as of this writing.

Coupled with the recent 48.1 percent dividend cut and new management’s announcement of an all-encompassing strategic review, Penn West looks like a compelling takeover candidate.

A current market capitalization of CAD5.9 billion makes the transitioning Penn West more than just a crumb. But there are Canadian giants–as well as international players interested in North American energy assets–more than capable of digesting it.

Penn West’s debt-to-assets ratio is just 18.6 percent, with the main concern a CAD3 billion revolver requiring rollover in June 2016, though there’s just CAD995 million outstanding.

Penn West has said it will outline its strategic focus the time of its third-quarter earnings release.

It’s likely the company will build its business around its Cardium, Slave Point and Viking assets. Management noted that there’s strong interest in its Duvernay properties. Debt reduction is the primary driver of asset sales, though divesting assets without taking too deep a bite out of cash flows and killing shareholder value will be a challenge.

Penn West, which has rebounded from its post-dividend-cut low, earns an upgrade to buy under USD13, but it’s only for the aggressive.

Current CE Portfolio Aggressive Holding Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF) is trading at an even steeper discount to the value of its resources, with a price-to-book value of just 0.44.

Lightstream’s debt situation is slightly more complicated than Penn West’s. Debt-to-assets ratio is just 23 percent, though there’s CAD1.2 billion drawn on a CAD1.4 billion revolving facility that matures too in June 2016.

Lightstream’s market capitalization as of the close of trading on the Toronto Stock Exchange on Thursday, Aug. 8, was CAD1.502 billion. That makes it a smaller bite for a potential acquirer, though debt is nearly equal to market cap.

As indicated by its “quick ratio” of just 0.2, Lightstream’s margin of error for debt service is perilously thin.

As we noted in last month’s Portfolio Update, Lightstream generates high netbacks for its light oil output but is extremely sensitive to swings in commodity prices. And its share price simply hasn’t responded to oil’s upward trend since December 2012, largely because investors are pricing in a dividend cut that management has thus far resisted but that now seems inevitable.

The decline from CAD15.08 as of mid-September 2012 to an all-time low of CAD7.61 on April 17, 2013, and CAD7.70 as of this writing–following another dive after the company reported second-quarter earnings–could make it a target for a bigger, more liquid company.

As we also noted last month, Lightstream is the cheapest oil and gas producer with a market capitalization greater than CAD1 billion on the Toronto Stock Exchange. It’s the fourth-cheapest among those valued at more than CAD100 million.

Second-quarter production averaged 46,045 boe/d (82 percent light oil and liquids), down 6 percent from the first quarter but up 19 percent year over year. Operating netback for the second quarter was USD50.08 per barrel of oil equivalent, a slight increase over the first quarter.

Funds from operations were CAD168 million, or CAD0.86 per share, down 5 percent sequentially but up 39 percent year over year.

Total dividends of CAD47 million were declared, representing 28 percent of funds from operations.

Average production for July is estimated to be approximately 44,000 boe/d, relatively flat to June production.

Management reiterated its annual average production guidance of 46,000 to 48,000 boe/d, reflecting growth of 8 percent to 12 percent over 2012 levels.

Lightstream boosted its CAPEX forecast by 5 percent to CAD700 million to CAD725 million as a result of cost overruns as well as higher-than-anticipated drilling and completion costs on exploration wells drilled in its emerging play areas where it’s applying innovative techniques to delineate and de-risk new plays.

Management also boosted its annual funds from operations guidance by approximately CAD40 million to CAD680 million to CAD720 million.

Lightstream Resources is a buy for aggressive investors up to our reduced buy-under target of USD10.

Note that the US over-the-counter (OTC) symbol for the stock has changed to LSTMF.

Talisman Energy Inc (TSX: TLM, NYSE: TLM) is trading at a slight premium to book value, but it too, like Penn West, is currently engaged in a strategic review initiated by new management.

As is the case with Penn West, Talisman’s self-study could result in the divestiture of non-core assets. But it could end in a sale of the entire company.

In fact Talisman has topped lists of potential oil-and-gas buyout candidates throughout 2013.

In fact it was named a target as far back as October 2011, in the aftermath of the announcement of the acquisition of Daylight Resources Ltd by China Petroleum & Chemical Corp, better known as Sinopec (Hong Kong: 386, NYSE: SNP), and again in October 2012, after Hal Kvisle’s first quarterly report as CEO.

Talisman is an CAD11.9 billion company, which makes it the eighth-largest oil and gas producer in market-cap terms listed on the TSX. It’s also the third-cheapest on a price-to-book basis among the top 20, “trailing” Penn West at 0.68 and Aggressive Holding Enerplus Corp (TSX: ERF, NYSE: ERF) at 1.11.

For a Canadian major looking to make a big move Talisman could be ripe. Its overseas assets also make it a potential target for a major international producer. Talisman is a speculative buy for aggressive investors under USD12.