Description

Suncor is the largest energy company in Canada – an integrated E&P and refiner of crude oil.  We think the stock (US$ ADR SU) is worth $35, 20% upside to today, and see clear near-term catalysts to bridge the value gap.   Suncor has been buffeted by several problems this year, which creates the opportunity:

(i) a large wildfire in 2Q that led to nearly $1B in losses and stock underperformance,

(ii) a hostile takeover of Canadian Oil Sands (COS) whose benefits have yet to been appreciated,

(iii) some investor misunderstanding of unit economics.

While energy investments are often difficult if one lacks a strong view on commodity prices, we believe Suncor will work at $50-60 oil.  We do not underwrite oil price appreciation to generate returns.  If you believe oil is going to $30-40 you can hedge this idea, as many other oil stocks are pricing in $60-70 oil already.  Suncor has lagged, and we think it has started to catch-up and will continue.

Our thesis:

(1) Suncor is more akin to a manufacturing asset than an E&P, with 40+ years of lower cost production;

(2) Management did a hostile takeover at $28 oil in January that will generate strong cash flow;

(3) The Alberta wildfire has obscured major underlying progress in the production and cost structure;

(4) Ramping production and falling capex will create a wall of FCF, which mgmt. will use for buybacks;

(5) Weaker 2016 stock performance means Suncor is at a 9% FCF yield on $50 oil vs. peers at 5-6%;

(6) The Street is underestimating FCF, which will begin to come to light at 3Q.

Oil Sands Basics

If you are well-versed in Canadian oil sands this section will likely seem a bit boring and over simplified.  For newer investors we thought it was useful to outline the basics.   Suncor produces 87% of its oil from Canadian oil sands in the province of Alberta in Canada.  Canadian oil sands are a mixture of sand, water, and bitumen.  Bitumen is oil that is too heavy and thick to be pumped as a liquid without further processing - a slick sludge having the consistency of cold molasses.  It has an API higher than fresh water, such that it would sink in water.

There are two different processes Suncor uses to extract the bitumen – open pit mining and in-situ SAGD.  Mining uses trucks and shovels to extract bitumen near the surface.  In-situ techniques use a pair of horizontal wells – one used for steam injection, and the other for oil recovery.  In-situ can extract bitumen that is deeper in the ground, and the projects are generally lower cost than mining.

For both mining and in-situ, the initial costs of building an oil sands project are high.   However, the ongoing operating cost for existing projects have fallen and are now relatively low for Suncor.  We believe that in a $50 oil environment these can over time approach $20 CAD/bbl, or $15/bbl USD blended.  Importantly oil sands assets have very low decline rates, so Suncor’s production does not need to be replaced with new projects like the majors.  The following graph from Suncor’s deck shows this dynamic – Suncor’s capex grows production while majors’ capex only stems declines.

There are some details to keep in mind on price realizations.  Oil sands product can go through a process called upgrading which converts the bitumen into higher crude grades such as Synthetic Crude which trade near WTI prices.  However, raw bitumen trades at a significant discount to WTI.  Suncor will upgrade roughly 70% of its product via onsite upgraders.

The following bullets summarize the oil sands:

Positive aspects of oil sands

(i) 40+ year life with close to no geologic risk.

(ii) Very low decline rates.

(iii) Ongoing cash costs are lower.

(iv) Strong realizations - production is 100% oil, versus lower priced natural gas.

Negative aspects of oil sands

(i) High initial upfront investment.

(ii) Long construction period.

(iii) Low price realizations if not integrated/upgraded (Suncor is integrated and has upgrading).

Old Suncor – Pre Steve WIlliams

Suncor was a poor generator of cash flow prior to the oil price downturn.   The table below shows the cash flow in 2011 to 2013 when oil was at $100/bbl.

(1) $3B CAD in FCF at $100 oil on a $62B CAD market cap today does not look at that exciting.  In fact, it looks poor.

(2) Utilization of the asset was poor at around 80%.

(3) Cash costs were high at $37-39 CAD per barrel

(4) Capex was high at $6B per year annually

Suncor Transformation

Current CEO Steve Williams took over Suncor in May 2012.  Williams, formerly of Exxon recognized several things about Suncor.  First, the key to lower costs was high utilization of the assets given the large fixed costs in oil sands.  Second, the operating culture fell short of what he saw at Exxon.  Third, capital was not being deployed intelligently.  Below I include an excerpt from his initial letter to Suncor shareholders in the 2012 annual report,

“We need to focus on continuous improvement in every aspect of our business, while also driving down the cash costs of our Oil Sands business.  We also agreed we would not pursue growth for the sake of growth.  Rather, we’d seek profitable growth through a relentless focus on capital discipline and operational excellence, while delivering increased returns to our shareholders.”

Williams stuck closely to his words (as has long been the trend at Suncor), and took action immediately and cancelled the Voyageur upgrader project in early 2013 to reduce capex, taking a $1.5B charge.   Subsequent to this cancellation, costs and utilization started to improve as the culture of the organization began to change and new innovations such as autonomous trucks were brought into operations (excluding the quarter with the wildfire – 2Q16).

There was an initial round of cost improvement prior to oil’s fall, followed by a more aggressive $1.7B cost cutting plan after oil crashed.  The sources of the cash cost come into four major buckets: (1) Productivity – workforce cuts, automation, (2) supply chain optimization, (3) Business process improvement – streamlined reporting, reduced fly-in-fly out, (4) operational – improved maintenance culture/schedule.  Suncor has further benefitted from the cancellation of many oil sands projects in Fort McMurray, which has reduced labor costs in the region (a trend that should continue so long as oil stays below $60/bbl).   This stands in contrast to U.S. shale where activity is likely to ramp more aggressively.

Despite all this positive change, investors were denied the opportunity to see the fruits of Williams improvements as the oil price began to crash in late 2014.   The Alberta wildfire in 2Q16 further obscured the second round of cost cuts (Suncor burned cash as its operations were completely down for over a month).

There are also two higher-level datapoints to think about to appreciate Suncor’s low cost structure:

(1) Suncor has previously stated that it covers its sustaining capex and 3% dividend yield near $35 USD oil;

(2) Suncor’s own metrics show that it generates more cash flow per barrel of oil produced than nearly any other oil company in most quarters.

Since few other producers can generate as much cash as Suncor per barrel, and Suncor can break-even at a lower price than most other companies – we think that it is near the low end of the cost curve.  At the Barclays conference in September Steve Williams said, “So in terms of cash generation per barrel, we tend to be the number one in North America and you will see that continue through the second quarter into the third quarter.”

Suncor Exhibit on Cash Flow Per Barrel

Hostile Takeover, Production Ramp, and Capex Cliff

Steve Williams did something that no other large public oil company did during the downturn – he executed a hostile takeover (of publicly traded Canadian Oil Sands) when oil was at $28 per barrel (within $2 of the daily low, so not too shabby).   This acquisition combined with the existing Fort Hills and Hebron projects (sanctioned prior to the oil price crash), which will complete in late 2017, create an interesting trend where production will ramp and capex will roll-off.  We believe the combination of higher production, lower capex, and lower costs mean a wall of FCF.

Below is a table showing our production and capex estimates through 2018:

The production growth is driven by Suncor’s hostile acquisition of Canadian Oil Sands and Murphy’s stake in Syncrude, as well as the ramping of Fort Hills and Hebron.   Syncrude is another oil sands site that is contiguous to Suncor’s site (we will come back to this asset later).  Suncor was already an owner in this oil sands project, and took its stake up to 54% through these deals.  Fort Hills is a 90kbpd oil sands project that will come online in 4Q17.  Hebron is an offshore asset off the east coast of Canada that will also begin production in 4Q17.  Both of these were commissioned prior to the oil downturn.

Our capex forecast is more non-consensus, as some on the Street expect higher capex spend.  Below are our forecasts by segment, which suggest that capex could be $4B in a $50 USD oil environment.  The reason for the drop-off in capex is that Suncor has not commissioned any new growth projects and will be returning cash to shareholders.   Steve Williams alluded to this at the recent Barclay’s conference where he said, “The strategy is focused on optimizing the base business, pursuing profitable growth, and returning cash to shareholders, and I suspect we’re coming into a period where that will take more – even more – weight than we’ve seen in the past.”

Our Suncor Capex Forecast

Syncrude Synergies

An additional source of upside in the Suncor investment case is Syncrude synergies.  Syncrude is an oil sands asset in which Suncor previously owned a 17% stake, but recently bought out Canadian Oil Sands and Murphy Oil to control 54%.  If Suncor’s operating track record prior to 2012 was bad, Syncrude’s track record was very bad.   Syncrude’s upgrader historically operated with utilization rates in the 70s, and breakevens in the $50+ per barrel area on an operating basis.  The reasons for the poor performance are many – but the main one is cultural – Exxon which operated the asset did not send its most talented people to work at Syncrude, and the multi-owner structure created more of a science experiment culture than a streamlined operation.  Maintenance was done on a break-fix basis and break-downs were frequent.

Suncor put out a relatively aggressive set of materials describing the problems at Syncrude during the hostile takeover which can be found here: https://www.sec.gov/Archives/edgar/data/311337/000119312516421328/d114280d425.htm

Suncor reached a deal with the Board of Canadian Oil Sands on January 18th 2016 with WTI crude at $28.

The opportunity for synergies is quite large for several reasons:

(1) Suncor and Syncrude’s facilities are contiguous;

(2) Suncor knows the assets intimately since it was a shareholder;

(3) The assets were operated poorly;

(4) Oil sands cost is about utilization – by integrating the two plans with an inexpensive connection utilization of both plants can improve dramatically.

Map of Suncor and Syncrude Facilities

We believe that better operations could yield 90% utilization vs. the 70% utilization previously achieved.  Indeed, even before any work from Suncor Syncrude delivered 90% utilization in 1Q16 and may do so again in 3Q16.  This seems to be from improved culture following the embarrassing hostile takeover which highlighted Syncrude’s poor performance.

From a high level perspective, Syncrude delivered $42/bbl cash costs in 2015.  At 90% utilization cash costs could decline to $30 per barrel.   On 170kbpd, that is an improvement of $700M in cost savings.  And that is from improved utilization only.  There are additional synergies from mundane improvements such as consolidating bussing/helicopter systems, purchasing and other tasks, as well as staff upgrades.  More importantly there are larger structural synergies from integrating the two plants physically.  Since oil sands is based on uptime – why not build a bridge between Suncor and Syncrude allowing each facility to “stand in” if there is downtime at the other.  We think this is exactly what Suncor will do.  All told we think synergies at Syncrude could approach $800-900M over time.

The Refining Business

Suncor is an integrated producer and operates 4 refineries – Montreal (137kb/d,), Sarnia (85kb/d), Edmonton (142kb/d) and Commerce City (98kb/d).  All of the refineries except Commerce City are in Canada.  The refining business is generally tougher to model, but the most important thing to understand is that in Canada, especially Suncor’s core markets, refining is more of an oligopoly.  Suncor calls them logistical islands.  In Edmonton for example there is Suncor’s, Shell’s refinery, Imperial's refinery, and not much else.   This means behavior tends to be more rational and profits are more stable than in other areas of refining (though this is certaintly not a consumer staples business).  Shell rates its Edmonton refinery as the top quality refinery in its entire worldwide network.  The quality of the refineries can also be seen in this exhibit from Suncor, which shows that similar to our oil production our refining earnings per barrel is consistently above other refineries.

While we do not profess to be experts at modeling refining (I’m not sure anyone is), we note that 2016 was a tough year for refiners.  Suncor, however, is the only refiner we know that did not cut its guidance.   At the beginning of the year it expected to do $2-2.3B in cash flow from operations and now it is on track to do $2.3B.  Below is the history of Suncor’s refining cash flow:

The data shows that SU average cash flow is around $2.3B, though in exceptional periods (shale boom) it can be as high as $3B, or poor periods (recession) as low as $1.5B.  Since we expect shale production in the US to ramp up and the economy to remain generally healthy, we think refining cash flow can likely stay above $2B in the next few years.

Note also that Suncor has a retail network of 1475 Petro Canada Stations, which is included in the refining result and helps stabilize overall performance.

The Offshore Business

Suncor has a small offshore business that produces roughly 100kbpd with wells in the North Sea and Eastern Canada.  This is not a controversial business and at $50 oil should be able to produce cash flow from operations of approximately $1.5B.

Putting it All Together

In the last month Suncor stock has outperformed energy indexes by ~7% after lagging for the better part of the year.  We believe recently analyst notes are highlighting the emerging power of the cash flow to the Street.  Note that our capex forecast differs from the Street.  Our cash costs are also lower (lower 20s vs. $27 for many on the Street in a $50 oil environment), an EBITDA impact near $1B.  We would buy the shares ahead of 3Q, as we believe management may make the story more clear.  Our FCF forecasts for SU at $50 and $60 oil:

Base Case - $50 WTl in 2018

Base Case - $60 WTI in 2018

We find these valuations highly attractive relative to the US majors, many whom trade at a 5.5% FCF yield at $50 and an 8% FCF yield at $60.  We further believe that the large bulk of this cash flow will be returned to shareholders.  Our estimates do not include an upside scenario where Syncrude synergies could be above our forecast.

Catalyst

We see several imminent catalysts which will realize value at Suncor:

1) 3Q earnings should highlight lower cash costs;

2) By year-end, we expect a specific plan for Syncrude synergies

3) In November, Suncor will highlight its 2017 capex and cash cost guidance

4) Between now and year-end we expect a more specific multi-year plan for capex and cash cost

5) Potential additional accretive acquisitions