Newsletter Value Investor Insight carried an interview with Fairholme Capital's Bruce Berkowitz (pictured left), Larry Pitkowsky and Keith Trauner in its April 28th edition. The Fairholme Fund has returned 18.7% per year since its launch in 1999, versus a 0.4% annual loss for the S&P 500. Here's the segment of the interview in which they explain why their fund's largest long position is Canadian Natural Resources (CNQ), which was trading at $60.02 at the time of the interview:
Tell us more about your largest energy holding, Canadian Natural Resources (CNQ).
BB: This is a diversified oil and gas company that I’d never heard of before we started looking into it, even though it had about a $10 billion market cap at the time. As I said earlier, we’re very impressed with the management, which has an outstanding track record of success across several market cycles and now has over $1 billion invested in the company. We think this will be a household name one day.
The company is moving from a reliance on natural gas and heavy oil to being a light, sweet-grade oil company. That will happen as they continue to develop their Horizon oil-sands project in Alberta, which has no exploration risk. The upgraded oil from the sands will be a light synthetic crude oil that will get a premium price to West Texas intermediate.
Right now Canadian Natural produces more than 500,000 barrel equivalents per day in traditional production, which will roughly double over the next seven years as Horizon starts up and they develop other conventional assets.
Doesn’t the sheer magnitude of the Horizon project scare you?
BB: It is an enormous project. The first stage will cost $6 billion to begin producing synthetic crude in three years. They’ll spend more than $15 billion on the entire project by the time they’re done. But the amazing thing is that it will all be funded from free cash flow, with no additional debt. We also like that they’re not sacrificing any of their conventional business – they just had a nice find off the coast of West Africa and they have other promising development projects in South Africa.
KT: The market does seem concerned by the execution risk, which is not ridiculous given some of the disasters others have had with time delays and cost overruns on oil-sands projects. But we’re very comfortable with these guys’ track record of delivering on exactly what they say they’re going to do.
Do the oil-sands economics only work at high oil prices?
KT: They’re looking at an operating cost of less than $18 per barrel coming out of Horizon. They’ve based the economics of the project on $28 oil, and at that level expect to earn a double-digit IRR.
BB: We’ve already talked about our macro view of the price of oil, but we bought here into a management and at prices that made us not worry too much about the price of oil. We certainly don’t need prices to stay at current levels for this to be a great investment. We’d argue now that further oil-price increases wouldn’t be welcome. You don’t want to push the world into recession, or to prompt governments to start slapping tariffs and surcharges on oil. CNQ stock, now around $60, has been on a bit of a tear. How are you thinking about valuation?
BB: It still trades at less than 10x free cash flow of about $6.50 per share, for a company with the ability to double production and triple free cash flow over the next eight years without having to add any new assets.
This is one where we don’t really have an upward value range on it, because the numbers get crazy. They have six billion barrels of recoverable reserves in the oil sands and another three billion barrels in heavy oil/bitumen properties. That’s nine billion barrels of oil before you even talk about their conventional oil and gas reserves, which are approaching the equivalent of 2.5 billion barrels.
KT: The assets aren’t exactly the same, but Chevron bought Unocal in 2005, on average, for $12 per barrel in the ground, although much of that related to lower-value gas reserves. Apache Corp. (NYSE: APA) announced just last week that it paid the equivalent of $22 per barrel in the ground to buy 18 Gulf of Mexico properties from BP (NYSE: BP). Applying anything like those numbers to Canadian Natural’s assets, and, as Bruce said, the upside does get crazy.
BB: We know that if oil goes down to $40, this stock probably gets hit hard. But based on our long view on the price of oil and the company, that will be a hell of buying opportunity.