Description

Suncor is the largest integrated energy producer in Canada. 

The stock offers over 100% upside to fair value today, assuming WTI oil prices of $55. It has excellent downside protection, with a fully-loaded cash flow breakeven at $35 WTI, and a robust balance sheet that allows it to weather extreme volatility, such as what occurred in 2020 due to COVID-19. It trades at only 6x FCF, and FCF is expected to grow 20% by 2025, with no increases in production.

Market FUD over peak oil, battery electric vehicles, and COVID-19’s impact on the global economy has created an opportunity to buy a resilient, diversified business that can make money in an extremely wide range of energy price environments.

Background:

Suncor’s core business is extracting oil from its oil sands resources in northeast Alberta, where it has 30+ years of resources in the Athabasca oil sands, one of the largest resources in the world. It complements this with a refining operation that refines its own crude into finished fuels and petroleum products for North American markets, a retail marketing operation that sells fuels directly to customers at 1,700 gas stations in Canada and the US, a smaller offshore oil and gas operation, and interests in a variety of wind and other renewable energy projects. 

The integrated business model -- Suncor calls it “from ground to gas station” -- smooths operational volatility, as refining and marketing can offset maintenance stoppages in the oil sands business, and allows the company to maximize profits through tight coordination and ownership of the entire value chain. Because of this integration, Suncor’s refining operations earn 2x the EBITDA per barrel as the company’s closest peer.

Suncor’s core oil sands business has essentially no exploration risk, and is more like a manufacturing business than a traditional E&P company. Extracting crude from the company’s oil sands resources is a straightforward process using “in situ” methods like steam-assisted gravity drainage, or open mining where the sands are close to the surface. These oil sands operations have near-zero decline rates (in contrast with the industry, and especially with shale which declines very rapidly), and low cash costs which have been steadily declining for years, making underwriting of the business far simpler than it is for the company’s more exploration-dependent peers in the oil and gas business. Today, the cash operating costs of the core oil sands business are ~$27/barrel, and for the whole company, $30/barrel, including sustaining capex. After including the dividend, the breakeven is $35/barrel, and the company targets reducing this to $30/barrel by 2025. 

With such a low breakeven cost of oil, the company has substantial downside protection for a wide variety of oil price scenarios.

The Macro:

While I’m not a macro investor, it’s hard to invest in an oil company without some consideration for the common bear cases for the fossil fuel industry, from the growth in battery-electric vehicles to the potential for carbon taxes.

Here is how I got comfortable investing in a company that is so tied to fossil fuel prices.

1. Battery-electric vehicle threat is smaller than it appears

BEV penetration is growing rapidly but is still very small. It hit 2.5% of all light electric vehicle sales in 2019 according to McKinsey. But it’s the percentage of total stock that counts for oil consumption, and in 2020, that had only grown to 1% of the total global car parc. Morgan Stanley estimates that by 2030, 30% of cars produced will be BEVs, but since cars have an average lifetime of 10-12 years, even 30% annual penetration replaces just 3% of the global fleet each year. Even with rapid growth in BEVs it will be many years before they replace enough of the global fleet to make a material dent in oil used for transportation.

2. Oil isn’t used just for transportation

About two thirds of oil is used for transport, but the other third is used for a multitude of other purposes, for which there is no great substitute. If you look around, from your fleece vest to your running shoes to your widescreen monitor to the interior and bumpers of your car, there are oil-based products all around. To replace all of these plastics and other petroleum-based products with another feedstock at mass scale anytime soon is improbable. This pre-pandemic set of estimates from McKinsey shows growth in share for non-transportation uses offsetting slowing growth from transportation through 2030.
https://www.mckinsey.com/industries/oil-and-gas/our-insights/petroleum-blog/5-key-signposts-that-will-set-the-cost-of-the-marginal-barrel-of-oil-in-the-long-term 

3. Oil demand is still expected to grow slowly through the 2030s 

As a result of 1) and 2) and other factors, oil demand is still expected to grow over this decade before plateauing over the next.

https://www.iea.org/reports/world-energy-outlook-2020/outlook-for-fuel-supply 

4. Investment in new oil production has fallen dramatically

Even as oil demand is expected to keep growing slowly or be stable for years to come, investment in new oil production has plummeted over the last several years. Oil is a commodity which requires regular replacement, with about 5% natural depletion each year. If demand grows 1-2%, and production naturally declines 5%, the industry needs to replace 6-7% a year with new investment. Projected capex for 2021 is down 56% from its peak in 2013, while demand for oil has grown 5%, according to estimates for 2021. By next year, when demand is expected to return to pre-pandemic levels, demand will be up 8% from 2013. 

https://www.naturalgasintel.com/u-s-eps-reining-in-capex-while-international-operators-spending-more/ 

This lack of investment will catch up to the market, and drive oil prices which justify re-investment. That means that prices should normalize around the marginal cost of production, which is widely considered to be in the $50-60 range. https://www.mckinsey.com/industries/oil-and-gas/our-insights/global-oil-supply-and-demand-outlook-to-2040 

5. Carbon taxes will not change the outcome

While global or national carbon taxes would impact demand somewhat, the impact should be felt by the highest cost producers the most, rather than a company like Suncor that operates far below the marginal cost. Suncor already expects carbon taxes of $170/tonne in Canada by 2030, and has estimated that this will add $0.46 in cost to each barrel of oil they produce -- i.e., a 1-2% tax on their cash margins. This would not have a material impact on the upside to fair value in the stock, and this is before any potential offsets, as Suncor is actively investing in growing its renewable fuels production capacity and in carbon capture and sequestration technologies which could make the company a recipient of tax credits. Rather than resisting carbon taxes, Suncor is actively lobbying in favor of broad-based carbon pricing.

6. Valuation provides a margin of safety

Suncor’s deep discount to intrinsic value provides a substantial margin of safety should I be wrong on any of the above factors. With a cash cost breakeven at $35 and declining, and the company trading at 5.5x FCF and returning most of its cash flow to investors, oil demand and oil prices can be a lot lower, and carbon taxes can come a lot sooner, and I still won’t lose money.

Current Opportunity:

Over the last five years, Suncor was focused on production growth, and increased its net production from 600 to 800kbpd. For the next five years, Suncor has prioritized “value over volume,” committing to hold production stable even if oil prices climb substantially, and seeking to maximize its asset utilization and margins. With planned capex limited to maintenance, de-bottlenecking, and other efficiency and technology projects, free cash flow (which the company calls free funds flow) is expected to climb significantly. This is what makes the company so attractive right now.

Suncor is expected to generate about C$10 bn in operating cash flow (FFO) this year, and $6 bn in free cash flow, so today it’s trading at a 17% FCF yield, or ~6x 2021 FCF.

From 2021 through 2025, the company plans to grow its annual FFO and FCF by C$2 bn (about 20%) from a variety of cost savings, asset optimization, and technology initiatives. Over the five year period, it expects to cumulatively generate about $53 bn in FFO at $55 WTI, and plans to return approximately 60% to shareholders through dividends, share buybacks, and debt reduction. This equals ~90% of the current share price! 

See this chart from the company’s May investor day:

So within five years, an investor will receive back nearly all he or she paid if the company hits its targets!

With the company focusing on lower risk maintenance capex and efficiency initiatives rather than production growth, I have reasonable confidence in the company achieving these targets.

Valuation:

To estimate fair value, I assume a long-term oil price of US$55, which appears to be the consensus on the marginal cost of production and where I believe long-term oil prices should normalize. With oil prices at $65 today, this gives some cushion in the model.

I assume the company gets most but not all of its targeted increase in FFO over the next 5 years, resulting in approximately C$11.8 bn FFO in 2025. I assume that capex is roughly C$5 bn, in-line with the company’s guidance. This results in FCF growing about 16% from ‘21 through ‘25, somewhat more conservative than the company’s targets. Assuming the company uses about ⅓ of its cash flow for buybacks results in a share count reduction of about 16% over that period, and FCF/share growth of ~40%, from my estimate of about C$4/share this year, to roughly C$5.50 in 2025.

There is material upside potential to my FCF estimate if oil prices remain higher or if the company fully delivers on its target for $2 bn of FFO growth by 2025. The company has raised its outlook for WTI in 2021 to $65 a barrel, in-line with today’s prices. Given the massive underinvestment in new oil since 2013, there seems to be a good chance of oil prices overshooting their long-term margin cost of production. At $65 oil, the company could generate almost C$8/share of FCF in 2025, or almost 40% more than my estimate at $55 oil, showing the significant upside leverage to oil prices inherent in the business.

To value the company I use a discounted five-year forward multiple of 9x on 2025 FCF of C$5.50 to arrive at a fair value target of ~C$50, or 115% upside to fair value. I think on a normalized basis this company is worth the long-term average, one-year forward market multiple of ~16.5x, which I discount at 11.5% per year to get to 9x for a five-year forward multiple. Today, the market trades at a nearly 30% premium to its long-term average, so if the company traded at its long-term run-rate FCF and 16.5x today it would still be well below market.

Flexibility and Resilience:

Suncor’s performance during 2020 demonstrates how flexible and resilient the company can be during periods of extreme stress, which bolsters the case for the margin of safety and downside protection in the name. When oil prices and oil demand both collapsed last year, Suncor was able to slash planned capex by 30%, and opex by 12%, and reduce its fully-loaded breakeven from $45/barrel WTI to $35. With an investment-grade balance sheet and low leverage (only 1.5x net debt to FFO), the company was able to raise capital in the debt markets at low rates to increase its liquidity. Additionally, the company was able to flex its integrated model and consistently achieve higher utilization from its refineries than the industry averages. The company’s ability to rapidly adjust to severe changes in the environment, and the financial flexibility provided by a strong balance give confidence that the company can weather challenges in the future.

Summary:

Suncor presents an opportunity to invest in a low exploration risk, steady producer of energy with very low cash costs, and therefore excellent downside protection, and remarkable upside if oil prices remain near their long-term marginal cost of production or overshoot given recent underinvestment in new capacity. The company has prioritized value maximization over volume growth for the next 5 years, thus reducing operational risk and increasing the likelihood of hitting its targets.

Furthermore, the company has committed to returning nearly 100% of the price of today’s stock to shareholders over the next 5 years, dramatically reducing tail risk. If you buy Suncor today and it hits its targets, you get almost all your money back in 5 years and then you get to stick around for whatever value is left in the company. My bet is that there’s a great deal left in the tanks by then, given the challenge of transitioning the global economy away from fossil fuels, and the company’s efforts to pivot as that transition occurs.

A Note on ESG:

For those concerned about ESG risks, Suncor is at the forefront of reducing greenhouse gas emissions in its industry, having recently committed to achieve net-zero carbon emissions by 2050, and leading its four largest peers to join in this commitment, representing 90% of oil sands producers in the country, and about 10% of Canada’s total greenhouse gas emissions, representing a massive potential impact. Suncor has been a champion of best practices in ESG for many years, first reporting on sustainability over 25 years ago, and first launching quantitative emissions and impact reduction goals 12 years ago. Their most recent targets include reducing their GHG intensity 30% by 2030 from 2014 levels. This spring they added a new long-term target to achieve net-zero emissions by 2050 and an additional target of reducing their absolute GHG emissions by 10 megatonnes by 2030, on top of their existing target of 30% reduction in emissions intensity. As an energy-intensive business, if Suncor can achieve these targets, it will make a bigger positive impact on the planet than a host of other “normal” companies greening up their own operations.

Catalyst

Execution on cash flow growth
Shareholder return
Rebound in global demand for energy