Description

All financial metrics are in CAD except for oil prices, which are in USD.

Canadian Natural Resources Limited (CNQ) is one a $100 billion market cap E&P oil and gas company in Canada. CNQ operates globally, but its core assets are North American conventional oil and gas reserves as well as massive reserves in Canadian oil sands, including the Horizon project.

We believe CNQ presents an attractive investment opportunity even after impressive share price performance over the last several years.

LONG LIFE, LOW DECLINE PORTFOLIO OF ASSETS

Following the completion of Phase 3 of the Horizon oil sands project in 2017, CNQ transformed its reserves to long-life and low-decline. Today, CNQ has a total proved reserves life index of 33 years and a total proved plus probable reserves life index of 43 years. Such long asset life essentially makes CNQ a long-duration asset, unlike conventional E&P companies (and especially shale oil companies), which have to keep investing in discovering new oil just to stay afloat. Based on the 2024 production mix, the company reports an 11% corporate decline rate (needing to replace 11% of reserves every year to keep them stable). Such a low decline rate is driven by 58% combined production share from 0% decline rate in Oil and Sand mining assets as well as a 13% decline rate in Pelican and Thermal assets.

The benefit of having low decline assets is that it gives you a lot of capex flexibility – in the case of a rapid decline in oil prices, CNQ can slash capex, thus supporting FCF, unlike conventional oil companies that are hit both on revenue and capex side in downturn. Such a low decline asset base allows CNQ to pursue opportunistic M&A when everyone else is playing defense. Below is an excerpt from our conversation with the company:

The perfect example is 2020. Our capital program was $5 billion. We had some growth in there. When COVID hit and pricing went down to very low levels, our first thing that we were able to do was cut capital. We have a very flexible capital program down to our maintenance level or even below for a period of time. If it makes no sense to grow, we're not going to spend that capital. If it doesn't generate returns, we won't do it. We cut capital all the way down to $2.7 billion pretty much overnight. We were the only company in Canada that year to grow production. We still grew production even though we cut the capital, we maintained our debt levels. Even increased the dividend. Most peers either maintained their dividend or cut it. We were able to maintain all of that and execute on our plan because of our asset type.

The company retains opportunities for substantial organic growth. In the conventional E&P segment, they see opportunities to increase production from approximately 600 MBOE/d to 1,100 MBOE/d by leveraging available facility capacity, debottlenecking, and expansion opportunities. In Thermal In Situ Oil Sands, there is an opportunity to add 300,000 bbl/d of incremental capacity through project expansions combined with solvents. In Oil Sands Mining and Upgrading, there is long-term development potential to increase production from the current 450k bbl/d to 1,300k bbl/d through a combination of applying new technologies, debottlenecking, and project expansions.

The majority of current capex goes towards maintenance purposes. Out of the $5.4 billion 2024 capex budget, only around $1 billion is for growth projects; this should be enough to grow production by low single digits.

To summarize, the company has ample organic growth opportunities in the near-to-midterm. The biggest bottlenecks for faster growth have been 1) limited egress capacity and 2) regulatory regime uncertainty related to carbon emissions policy. While the former has been addressed, at least for the next several years, with the launch of the Trans Mountain pipeline this year, the situation around carbon emissions regulation in Canada is still evolving.

OPPORTUNITIES FOR FURTHER COST EFFICIENCIES

Oil sands production did not reach scale until the early 2000s, which means the industry is still fine-tuning the amount of steam and solvent needed to extract oil-like bitumen out of oil sands. According to energy research firm Wood Mackenzie, operating costs per barrel for Canadian oil sands have declined about 19% over the last five years. The major Canadian E&P company Suncor this year said that by the end of 2026 WTI crude oil price at which it can reach corporate break-even could come down by $10 a barrel, or about 19%.

While CNQ does not guide for operating costs, their track record of cost reduction speaks for itself: the company achieved a $13/bbl reduction in operating cost per barrel since 2014 at their Oil Sands Mining and Upgrading segment. This is equal to $2.1 billion in savings in annual operating costs in 2023.

CNQ does not get into much detail on their cost reduction plans, saying that their “teams are actively seeking small incremental cost savings opportunities throughout the operations, which collectively contribute to overall cost reduction efforts,” but it’s worth highlighting several strategies:

• Leveraging fixed cost base at the Oil Sands segment. Oil sands is a high fixed cost business, so increasing production reduces cost per barrel.
• Solvents. As an example of applying solvents to improve performance, we can look at the Kirby South solvent SAGD pilot, which achieved a 45% reduction of steam-to-oil ratio (i.e., less steam is needed to produce a barrel of oil) and solvent recovery of 85% (more effective recycling of solvents used in the process). Such steam-to-oil ratio improvement is equivalent to a ~$1.00/bbl reduction in operating costs.
• Development of new technologies. Historically, CNQ has been actively investing in new technologies. Since 2009, the company has invested $5.2 billion in R&D, with $600 million invested in 2022. While some of these investments are directed towards longer-term projects and technologies like carbon capture and storage, others are targeted at more near-term impact like advanced data analytics, In-Pit Extraction Process (IPEP), solvent Enhanced Oil Recovery pilots, etc.

WORLD CLASS MANAGEMENT TEAM WITH A PROVEN TRACK RECORD OF CAPITAL ALLOCATION

To understand CNQ management and culture, we need to study its Executive chairman and one of the largest shareholders. In the late 1980s, CNQ was recapitalized by an investment partnership led by Murray Edwards, who subsequently grew the company by buying assets from oil majors leaving Canada. Such a strategy of buying assets from forced sellers made Edwards one of the richest people in Canada.

CNQ has a clearly stated capital allocation policy that includes four pillars: returns to shareholders, balance sheet strength, resource value growth, and opportunistic acquisitions. Starting from 2024, the company is returning all free cash flow to shareholders in the form of dividends and buybacks.

Unlike most management teams in the industry, this team clearly “gets” capital allocation: they pursue organic growth with very strict return hurdles, do opportunistic M&A, and return excess capital in the form of special dividends and/or share buybacks. Perhaps one of the most impressive achievements of this team is their stellar 24-year track record of growing dividends. While their track record of value creation speaks for itself, it’s generally less understood what stands behind that track record. In our view, the key ingredients are:

• Culture of continuous improvement and operational excellence;
• Strong cost discipline leading to high capital efficiency;
• Counter-cyclical capital allocation.

I would like to dig deeper into their capital allocation philosophy. Below is an excerpt from our conversation with company IR on how they think about return on capital:

“Return on capital employed is a term and a calculation that gets hammered to everybody, accountants, engineers, if you don't know what our return on capital employed is, you're going to have a problem around here. That's our first and foremost decision maker. We look at the returns the whole time, but specifically when you're doing our budget process, for example, we do a full cycle. Even if you're doing drill-to-fill type opportunities, we always fully bake in all capitals. We're not quoting any 70% return on capital numbers or anything like that because it's not right. We got full cycle capital built in with all your facility, capital and everything. Engineers go to their areas, come up with a plan and at a certain price level, anything that generates a 15% after-tax hurdle rate gets looked at. At a company of our size at $80 crude, you could spend $10 billion a year and meet returns. But what causes your own problems? You grow too fast, you worry about growth, you're going to cause your own inflation because you're quite large. We're not going to do that. You got a big pool of capital; big pool of projects and it gets high graded down to the best assets and the best returns.”

A big part of CNQ’s success is Edwards’ ability to hire and retain exceptional talent; the company enjoys a very low turnover rate. There is a strong ownership culture - every employee is a shareholder, which adds nicely to total compensation over time both through share price appreciation and dividends. Over many years in business, Edwards has developed his own business philosophy, which he calls “three Ps”: people, plan, and passion.

In a speech to his alma mater, the University of Saskatchewan, Edwards told the students he owes his success to three things. "The first is to have a good team of people," he says. "An organization with a CEO that has everything functioning up and down from this one person is an outdated management style. Today, it's more like working in rectangular boxes where a team of people has different skill sets. If you put them in a room together and coordinate those skill sets, you can achieve far more as a whole than as an individual. My particular skill set is being a leader, a challenger, and a motivator." The second thing Edwards believes is necessary for success is to have a plan or a process. "You need a strong vision, a strategic plan, and a budget process," he says. "And the third thing you need is passion for what you do. Those three things, people, plan, and passion, along with a lot of hard work and a little luck, will get you to success."

Those looking at CNQ as just “another oil company” are risking missing the bigger picture of a special company with a unique culture, which arguably contributed to the outstanding performance of CNQ over the years.

VALUATION

Assuming $80/bbl WTI and low-to-mid single-digit production growth, we see $7.50-8.00 of FCF per share in 2028, which is equal to mid-teens IRR based on the current stock price of $48/share.

Catalyst

share buyback

changing investor sentiment towards oil and gas sector