Description

Issambres839 has posted this idea twice and did an outstanding job both times. This write-up builds upon his analysis and the related discussion. I argue that COS still has, despite its runup, about 50% upside to achieve fair value, as measured by a Discounted Cash Flow (DCF). I provide the DCF for a range of Discount Rate and Crude Oil pricing assumptions. I also flag a new catalyst that should occur this summer.

C$ are used throughout this discussion, except when otherwise specified. COS is listed on the Toronto Stock Exchange. In the US, it can be bought as COSWF, although this listing is not sponsored by the company.

Canadian Oil Sands (COS) is a Unit Trust that owns 35.49% of Canada’s Syncrude oil sands project (the world’s largest). It has 35 years of proved reserves, with more that are in the probable category. There’s virtually no production decline or exploration risk. Syncrude is in the tail end of a large expansion project (Stage 3) that will reduce per barrel costs and increase capacity 50% by the second half of 2006. Capex for this project will end this year. Syncrude produces Syncrude Sweet Blend(SSB) which typically sells for slightly below WTI grade Crude. After the upgrade, COS will be producing a higher grade of oil Synthetic Sweet Premium (SSP) which may even sell at a premium to WTI.

COS has debt of $1.7 Billion; Debt/Equity ratio is 64%. Their goal is to have debt down to $1-1.5 Billion, or a 30-40% ratio, at which point they would probably dramatically increase their distributions. Interest Expense is excluded from the DCF, since the project’s DCF should be evaluated independently of the financing. The debt financing is taken into account by including it in the Enterprise Value. 92 Million Units (shares) are used to convert to Unit Price.

The DCF runs for 35 years (the life of proven reserves), with no residual value. This gives no credit for probable reserves.

When thinking about this project, you should keep in mind that the major long-range uncertainties (Oil Price, Natural Gas cost, and Exchange Rate) can be largely hedged either by COS or an investor. There’s no real uncertainties related to marketing, obsolescence, or technology as happens when valuing most other companies. Operational risk is the only large uncertainly that can’t be reasonably hedged against. It’s a non-trivial risk. The environment in the winter is especially unforgiving and the petroleum business can be dangerous in any season. Bear in mind, however, that from a financial perspective the risk may not be that different from investing in a company dependent on one large factory or whose human capital is located near the San Andreas fault or in a large skyscraper targeted by terrorists.

A year ago, Issambres suggested that a 9% discount rate might be appropriate. Independent energy analyst Kurt Wulff uses 7%. I’m using 8.5%, but what’s a few basis points among friends. Remember that after 2007, you are basically dealing with a perpetuity, most of whose risks can be hedged.

For COS’ Crude Pricing, I use a discount from WTI of approximately US$1 for each year of the Strip from now until 2011. For years beyond 2011, I use US$45 as the COS price. This is significantly below the 2011 price of US$49.11. As a comparison, last quarter COS’ discount from WTI was C$0.49. For Crude Pricing I use an exchange rate of C$ / US$ = 1.2. As of the end of 2004, COS had no Crude hedges.

For Crown taxes, the DCF uses the minimum 1% of Revenues for 2005-2007, after which the tax rate converts to 25% of Cash Flow (Operating CF minus CapEx). I estimate CapEx for years 2005, 2006, 2007 at C$ 700Million, 200, 210 respectively. Then 220 for the remaining years.

The rule of thumb for Natural Gas (NG) pricing is a 6:1 WTI/NG ratio. This is based on the energy content of the two resources. NG is one of the principal cost components for COS (about 25% of operational costs). Currently, NG is priced below the rule of thumb at approximately an 8:1 ratio. I use ratios of 7.5, 7, 6.5 and then 6 for 2008 and beyond.

The risk that management will fritter the cash flow away is lessened by the nature of the Unit Trust, which limits the Trust’s ability to “diversify”.

Below are the results of the Discounted Cash Flow’s Sensitivity Analysis. Each column represents a discount rate ranging from 7% to 13%. Each row represents a different level of WTI pricing, ranging from 70% to 130% of the current strip. I believe that a discount rate of 8.5% and the Current Strip represents a reasonable scenario, but you can pick and choose. That scenario results in a Fair Value of C$124, vs the Current Unit Price of C$84.23. These numbers are after subtracting COS’ debt. Remember that you can hedge, either directly or indirectly, against a decline in the price of Crude. (Please excuse me if the formatting of the table gets messed up; I’ve never had much luck with inserting tables into VIC writeups)
___, 7.0%, 8.5%, 10.0%, 11.5%, 13.0%
70%, 64, 52, 43, 36, 30
85% 105, 88, 75, 64, 55
100% 146, 124, 106, 92, 81
115% 188, 159, 138, 120, 106
130% 229, 195, 169, 148, 131

Nothing is certain, but to me this looks like a pretty reasonable Margin of Safety.

Two negatives: In late 2004 the Canadian Federal Government implemented a 15 per cent withholding tax on all distributions made to non-Canadian unitholders. There are reports that Canada is breaking with precedent and is, based on this new law, attempting to withhold this 15% from IRA’s and other non-taxable accounts held by non-Canadians. This is a matter of discussion between the US and Canada, as to whether it is a violation of the United States - Canada Income Tax Convention. Without getting into the rights and wrongs of the matter, this is a negative which will (if not resolved) become bigger as COS’ dividends increase. Participation in the DRIP program can partially compensate for this.

The second negative is that COS’ indenture provides that not more than 49 per cent of its Units can be held by nonresidents. As of January 19, COS estimated that approximately 58 per cent of the Trust’s Units were held by Canadian residents, with the remaining 42 per cent held by non-Canadian. If the 49% non-Canadian ownership is exceeded, COS can force the sale of the most recently purchased units by non-Canadians. The catalyst described below makes this possibility less likely. Also, COS will probably eventually remove this indenture since COS management recently opposed the passage of a Canadian Federal Law requiring a similar restriction among unit trusts.

The catalyst is that in January S&P announced that it intends to include income trusts in the S&P/TSX Composite Index, probably in mid-2005. Previously, a number of institutional investors were precluded from investing in income trusts since such trusts were not included in the broad equity index against which they were benchmarked. This will tend to increase Canadian ownership.

Catalyst

Mid-2005 inclusion in the S&P/TSX Composite Index