Description

Summary

Canadian Oil Sands (TSE: COS, Pink Sheets: COSWF) is a producer of synthetic crude oil in Alberta Canada's Athabasca Oil Sands.  The stock is a compelling long at current prices having tumbled from over C$35 per share last year, to around $21.50 today despite healthy oil prices. 

The stock, sporting a 6.5% dividend yield, trades at a 11% FCF Yield, at a mere $6.27 per proved barrel, and has the potential to increase production by 20%+ between now and 2014.  Given the high fixed cost nature of the business, there is tremendous leverage to both increases in oil prices as well as production. Aggressive central bank actions around the world certainly support current oil prices, and likely push them higher.

Basics (C$):

Technically Canadian Oil Sands is a passive entity, owner of a 36.74% stake in Syncrude Canada Ltd. Syncrude is one of the largest crude oil producers from Canada's oil sands, operating 5 large oil sand mine trains, a utilities plant, a bitumen extraction plant, and an upgrading facility that processes bitumen into light sweet crude. The production from Syncrude is 100% light sweet crude oil.  The Syncrude Project's owners are:

Canadian Oil Sands (36.74%)
Imperial Oil Resources (25%)
Suncor Energy Oil and Gas Partnership (12%)
Sinopec Oil Sands Partnership (9.03%)
Nexen Oil Sands Partnership (7.23%)
Mocal Energy Limited (5%)
Murphy Oil Company Ltd. (5%)

The operator of the project, Imperial Oil, is a 75% owned subsidiary of ExxonMobil. So generally the oil sands project here benefits from top quality industry and production expertise.

As far as the oil in place, it is high quality crude often preferable to refiners than even natural light sweet crude.  It is literally dug up and surface mined from bitumen deposits in Alberta Canada's Athabasca Oil Sands.  To date, approximately 2.2 billion barrels of oil have been produced from this project, with proved reserves of another 4.8BB in place. That is simply a massive amount of oil in the ground, and with recovery rates of 90%, Syncrude will be able to produce steady amounts of oil for decades.

Even ignoring an estimated 5-7BB of additional contingent barrels in place, current proved reserves ensure that Syncrude has at least 40 years of oil production in the ground.  Different from producers like Exxon or Conoco who struggle via the drill bit coupled with acquisitions to simply keep production flat, Syncrude doesn't have to acquire any existing hydrocarbons (at higher and higher prices) to keep its production levels from declining. 

The model is simple here.  On the revenue side, Syncrude delivers the upgraded crude to COS for marketing purposes.  COS doesn’t hedge, instead opting to simply sell its oil at prices that historically have been slightly higher than WTI.  With net production today of 100,000 bbl/day through the first six months of 2012, revenue at $90 oil realized equates to annualized revenue of $3.3BB.

On the cost side, SG&A and operating costs costs are largely fixed to operate the mine trains and upgraders.  There are some variable costs associated with crown royalty taxes for example, but the net costs to Canadian Oil Sands (COS) work out to approximately $1.9BB per year.  That works out to $1.4BB in runrate EBITDA.  Guidance for 2012 is $1.52BB as production should improve somewhat in the 2^nd half.

Issues

Syncrude/COS has shown an uncanny ability to miss production guidance. In fact, for each of the past 4 years, management has guided to production between 110,000 and 120,000 barrels of oil per day. And yet the actual number has been below the bottom end of this guidance, every single year since 2008.

                    Midpoint of Guidance                                    Actual Production

2008                       115k bbl/day                                                       106k

2009                       115k                                                                  103k

2010                       115k                                                                  107k

2011                       115k                                                                  106k

2012 1H                   111k                                                                     99k

Part of the thesis here is that Syncrude’s capex program will dramatically improve production as well as the reliability of production.  Design capacity is 129,000 barrels per day, and once enhancements & replacements are made to equipment, then production should get much closer to this figure.  Missed guidance in the past has related to issues in the final upgrading stage, or from less efficient, older mine trains, which simply break down.

As background, Syncrude produces oil using giant mine trains that essentially do the following: 1) crush bitumen ore after it has been dug up, 2) feed the oil sands via a surge bin into a mix box, and 3) add warm water to the oil sand in the mix box to produce a pumpable slurry. Next, the sand is removed from the bitumen during the extraction phase, then dry bitumen is cracked by heat in cokers upgrading it to a final light sweet synthetic crude.

Between now and 2014, Syncrude plans to replace or relocate 4 of their 5 mine trains. Two mine trains at the company's Mildred Lake mine site will be entirely replaced, and newer wet crushing technology should improve recovery rates and lower maintenance costs.  Fortunately, production will not be affected during the process, although production snafu’s likely will continue until 2014.

In terms of the budget, in total the net cost to COS will be $3.0BB, with roughly $500mm spent to date.  While the original forecast called for $2.5BB with a 25% margin of error, today’s higher forecast has a tighter margin of error of 15%.  In my model I assume $3.25BB in total costs, as the 4 primary projects are now underway and costs visibility is improved.

There clearly is a huge overhang on the stock owing to heightened capex spending.  However, by the end of next year, the mine train projects will be roughly 60-70% complete, and much of the capital spending concerns should be behind them.

FCF
Maintenance capital expenditures are roughly $400mm.  In terms of the capex budget, total spending will be:

$1.1BB in 2012

$1.3BB in 2013

$1.2BB in 2014

$600mm in 2015

Afterward capex should normalize back to the $400mm range, perhaps even lower as newer equipment likely means lower maintenance.

Fortunately, 1) the balance sheet almost entirely unlevered today (at 0.1x Debt/EBITDA), and 2) all of this capex can be funded with free cash flow from operations and cash on hand. To ensure adequate liquidity, the company issued $700mm in bonds recently ($400mm of 2022s and $300mm of 2042s at 4.5% and 6% respectively).  With a 2015 bank line of another $1.5BB of capacity, the company has sufficient liquidity needed to fund capex over the next two years, as well as to fund dividends.

Even with the substantial capex initiatives for 2012 and 2013, the company will likely generate positive FCF. Excluding the non-recurring mine train project capex, Canadian Oil Sands should throw off $2.35 in FCF per share in 2012, and $1.78 next year (down due to some lumpiness in taxes).  By 2014, I expect over $3 in FCF per share and EPS well over $3 as well.

Here is my model on CF: 

Two things to note:  I believe oil price differentials will dissipate and use $100 oil prices in 2014 (more discussion below), and also assume 120,000 bbl/day of production that year.  This is a very conservative assumption on the production side, as design capacity is almost 130,000 bbl/day, and in smooth running quarters, the company has averaged as high as 118,000 bbl/day.  So in effect, I am only giving COS credit for a small ability to produce additional oil despite spending $3.0BB in capex.

Price Differentials

Historically COS has sold its SCO (Syncrude Crude Oil) at a small premium to WTI.  It has less sulfur and naptha in the feed, which is more ideal for higher priced jet fuel.  Lately however, as oil production has ramped up in the Midwest, COS has seen its differentials to WTI actually fall.  While last year COS sold its synthetic at a $5 premium to WTI, this year management forecasts a $7 discount. 

Political and environmental activism have made blocking an important pipeline (the Keystone XL extension) a symbol of the fight against global warming and protecting the environment.  While the Canadian government approved their portion of the pipeline, President Obama delayed a decision until 2013 after 10,000 protesters circled the White House.  This likely has moved completion of this until after 2015.

Nevertheless, there are multiple other pipeline expansions in the works that should help de-stock much of the pent up oil.  In fact the company has indicated that they have sold October (next month) oil at a $10  premium to WTI, after having sold September oil at a $10 discount. 

The company’s presentation/webcast has some good information about pipeline capacity expansion:

http://www.cdnoilsands.com/Theme/COS/files/Presentations/COS%20handouts.pdf

Sensitivities

Historically investors have eyed oil sand names with skepticism given the massive upfront building costs and higher operating costs on a per barrel basis.  In fairness there is more leverage with a name like COS compared to conventional oil producers who typically do not need to incur the high cost of building mine trains, upgraders ,etc. 

Below is a sensitivity of Cash Flow from Ops, and FCF to oil prices.  The table indicates that even at $70 oil, the company could be able to continue paying its current $1.40 annual dividend (although in all likelihood it would be reduced). 

** Assuming $400mm of maintenance capex.

Oil Prices

To cut to the chase, an investment in COS is really a levered bet on oil coupled with production upgrades that should help on the cost/barrel side.  While 10% production increases will flow straight to the bottom line, a commensurate drop in oil pricing (which we know can happen overnight) can easily demolish the production improvement thesis here.  

The good news is that 1) COS’ stock has massively underperformed oil over the past two years, and 2) while I have no idea what oil prices will be in the next month or two, I like being long oil after a pullback this week, especially amidst the beginnings of an inflationary QE program.  I argue that by the simple fact that since Jan 1, 2010, oil prices (WTI) are up 18%, while COS equity is down 16% (with dividends), the stock sell off seems overdone.

The table below is global oil consumption (in thousands of bbl/day).  The data below is far more impressive in chart format, but I think the eyeballing it gives some sense for even the muted cylicality of oil, with demand only falling cumulatively by 1.4% from 2007 to 2009 before jumping 2.8% in 2010.  

Since 2001, the CAGR in oil consumption is up 1.3%.  That may not sound like much, but in another 10 years, that means production will need to grow by another 7mm barrels of oil per day, from 87mm bbl/day to 94mm bbl/day.  

While some may view peak oil as a suspect theory, the facts support the notion that there isn’t unlimited oil in the ground, that there is a limit to technology as a means of extracting more oil, and oil discoveries are declining rapidly. 

The table below illustrates the amount of oil discovered globally (in billions of barrels) by decade.  By year, oil discoveries peaked in 1964. 

Evidence of peak oil theory is well substantited in the US, as oil production peaked in 1972 at 9.5mm bbl/day, and today continues at around 5.4mm bbl/day despite the best technology available and a favorable regulatory environment.  Even the much ballyhooed finds in North Dakota's Bakken Shale only amount to an incremental 0.4mm bbl/day.  We would need 10 Bakken Shales to get US production back to its 1972 peak.

According to the IMF too, oil production has largely remained flat since 2005, and spare capacity in the world is close to all time lows.  To me it is simply remarkable that amidst a near global recession, we continue to see very high oil prices.  While news of slowing growth continues unabated out of China, the July auto sales numbers showed 8.2% gains yoy including trucks and buses.  Not to mention that SUV sales skyrocketed by 30%.  China’s thirst for oil will continue to grow, although admittedly as lower growth rates.

Here is the IMF paper forecasting oil supply, demand and pricing:  http://www.imf.org/external/pubs/ft/wp/2012/wp12109.pdf. 

In sum, they conclude that it is 70% likely that oil will range within a 90 to 130 per barrel band by 2014, with a midpoint of approximately $116.  $116 would imply a near doubling of EBITDA from today’s levels for COS.

Comps

On the M&A side, it’s tough to find a comp that is relevant apart from the sale of another stake in Syncrude.  In June 2010, Chevron sold its 9% stake in Syncrude to Sinopec for $4.65BB. That implies a $51BB equity value for Syncrude, or a $19BB valuation net to Canadian Oil Sands equity. That is equivalent to $38.60 per share. It's quite conceivable that Exxon, as operator, or somebody else for that matter may want to increase its holdings of this investment, and buy out Canadian Oil Sands.

As far as trading levels, Suncor is the best comp to COSWF, and in fact owns 12% of Syncrude.  They both trade at approximately 12x TTM EPS, but Suncor produces a large amount of sour crude, with far bigger differentials to WTI of around $15-16 per barrel compared to $7 differentials expected for Canadian Oil Sands.  Suncor's much larger market cap (TEV of $55BB to Canadian Oil's $11BB) makes it less likely to be acquired, and surprisingly SU pays a meager 50c per share dividend.  

Finally, Canadian Oil Sand's $37 operating costs per barrel compare favorably to Suncor's $39 operating costs.  On a FCF/share basis, Suncor generated $2.02 in FCF/share last year but trades at $34.25 today (5.9% FCF yield).  COSWF generated $2.79 in FCF/sh last year but trades now at $21.50 per share.  Once the heavy capex cycle is over for Canadian Oil Sands, its FCF will revert back to these higher levels.

Other comparable companies include Canadian Natural (CNQ) at 12x 2013 EPS, Cenovous at 16x, Imperial at 12.2x and Nexen at 15x.  COS trades at 12x 2013 EPS, which I view as a trough year and still either inline or cheaper than the comps.  The yield plays in the US such as Linn Energy (the largest E&P MLP if memory serves) trade at 7% distribution yields, and given a 1.2x coverage ratio, imply a total FCF yield of 8.7%.

Valuation

I value COS on a FCF/share basis.  Before 2011, Canadian Oil Sands traded between 5% and 9% FCF yields. Since maintenance capex is only 50mm or so higher than D&A, I actually think EPS is a decent yardstick too, but less conservative given the escalating cost nature of operating in the oil sand industry in Canada.  Today, excluding this year's upgrading capex (for its mine trains which are clearly non-recurring), the 2012e FCF yield is 11%.  If I look two years down the road, and consider that the company could conservatively do $3.00 in FCF per share (using $100 WTI), then at a normalized or average 7% FCF yield, that implies a $43 stock price, which is a 112% return in two years including dividends.

If WTI oil remains at $100 in 2014, then it is conceivable that a two-thirds payout ratio on $3.00 in earnings (or $2.00 in dividends) could mean a 6% dividend yield (only 50bps tighter than today), or $36 per share including dividends.  That is a 68% total return in two years.  Even last year, COSWF traded above $35 a share, and is my minimum upside case by 2014.

As far as replacement costs go, COS has spent net 10.2BB in capital on its infrastructure. With a TEV at 10.9BB, it seems an investor in COS is getting the entire infrastructure, fully built and producing at near cost. 

My downside case is $75 oil, whereby the company would generate $1.25 in FCF per share.  At the lows in 2008 and 2009, the stock traded down to $15-17 per share, which seems possible again in another liquidity crisis or amidst another global recession.

My conclusion is that COS offers a skewed risk reward, albeit one that will not materialize overnight.  In a world of tightening medium and long term oil fundamentals, COS could be the biggest energy stock beneficiary to higher prices.  The downside seems tolerable here too.  In 18 months I can lose 5 bucks a share, and have a stock trading below replacement value.  Or in 18 months I can have a stock that could double simply on reasonable expected production increases plus some help from WTI.

In 2008 the stock traded north of $50 a share as oil spiked.  The company paid no taxes then, but it’s still a possibility amidst any supply shock in today’s market.  In a world of rising Middle Eastern tensions, this is a real possibility. It seems such a stock should be a staple in any portfolio, with the downside being a nice yield while I wait.

Other Items:

-          The company operated as a tax free (pass through) trust until converting to a corporation in 2010.  They will exhaust their NOL’s in 2012, meaning somewhat higher FCF this year, but lower next year as some deferred taxes come due.  I modeled the company in 2014 and beyond using a 20% cash tax rate, which I think is conservative given that corporate tax rates in Canada are 26%, offset by the ability to defer taxes based on accelerated depreciation of infrastructure PP&E.  Suncor for example paid roughly a 15% cash tax rate last year.  I am no tax expert though on Canadian energy companies.

-          Surface mining of bitumen is far less natural gas intensive than in-situ mining (required when bitumen deposits are greater than 75 feet in depth).  In fact, in-situ mining requires 4x the amount of natgas to produce, and therefore produces far more greenhouse gases than surface mining.  80% of Alberta’s oil sands are too deep for surface mining, offering some advantages to COS in terms of costs and environmental impact.

-          The company eventually intends to expand in the Aurora South field.  Management believes that bitumen production could be expanded by 50% in the early 2020 timeframe on existing leased acreage.  I have given no value to this valuable lease, but its optionality that is worth considering.

Risks:

Oil prices are the biggest, followed by differentials and unplanned maintenance outages.  Budgets could run far higher on the mine train replacements, and environmental concerns are always out there, especially as it relates to tailings and CO2 from burning natgas, etc.  Or, I could just be utterly wrong!

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