Suncor Energy Inc. (NYSE:SU) is an integrated Canadian energy company. The company is engaged in oil sands development and upgrading, conventional and offshore oil and gas production, petroleum refining, and marketing of crude oil and natural gas. The company operates primarily in North America and has some assets in Libya, and Syria.
Suncor Energy is trading at a significant discount on both the absolute and relative terms, as compared to its peers. According to my analysis, a fair price for Suncor Energy is in the range of $42-$44/share. The target price was arrived at using DCF-NAV for Suncor's oil sands and upstream business, 4.2X EV/EBITDA for its refining and marketing, and 13X EV/EBITDA for renewable energy business. While the Canadian oil and gas industry is struggling with high price differentials and all-time low price for natural gas, Suncor is relatively well positioned to weather these concerns more so than its peers due to the following:
Suncor is oil rich: Suncor's production contains 88% crude oil and its proven and probable reserves contain 95% crude oil. This is amongst the highest in the industry. In fact, Suncor is expected to divest more of natural gas assets due to prevailing low prices.
Not hostage to heavy/light differential: Suncor's oil-sands integrated upgraders (Capacity: 355,000 barrels per day) allow it to capture heavy/light differential. In FY 2011, Suncor upgraded 92% of low-value oil sands bitumen into SCO, which traded at a premium to WTI.
Increasing demand for SCO due to growing diesel demand to sustain SCO premium: Increasing diesel consumption and reducing gasoline demand in the US will increase demand for Canadian SCO as refining a barrel of SCO yields more diesel. This trend would also sustain the premium that Suncor's SCO gets vis-à-vis WTI.
Capitalizes on Brent-WTI differential: Through its oil-sands integrated refineries (Capacity: 460,000 barrels per day), Suncor converts low-priced crude into Brent priced refined products. In FY 2011, Suncor refined 431,000 barrels of oil per day. Growth in both the US shale oil and Canadian oil sands production would continue to depress WTI vis-à-vis Brent, increasing Suncor refineries' profitability.
Montreal refinery to become more profitable by 2014: With the reversal of Enbridge's line 9, the Montreal Refinery will be able to refine low priced oil sands crude into Brent priced products.
In-situ production growth to reduce costs by 25%: Suncor's oil sands production is moving towards 60% in-situ operations from 40% currently, which would reduce Suncor's oil sands production costs by 25% over the next 2 years. Consequently, Suncor's plan to realize 1 million barrels of oil equivalent per day by 2020 would not need proportionate investment in upgraders.
Suncor is especially a good buy at this moment for the following reasons:
Big bath in 2012 Q4: Suncor appears to have had a big bath in 2012 Q4 through the impairment charges of $1.487 billion when the EBIT would have otherwise been $0.9 billion, far lower than the $2 billion from Q4 2011. Consequently, Suncor's share price is depressed. However, I believe that the current price fully captures all the negative effects of impairment and its subsequent effects on 2012 earnings.
Suncor is far undervalued as compared to Cenovus Energy (TSX: CVE), Suncor's pure-play competitor. As natural gas price remains at an all-time low due to cheap and abundant shale gas, comparisons based on MBOE of daily production or reserves are not accurate. EV/2P-Oil and EV/MBOED*Net-Back per BOE are more relevant besides EV/EBITDAX. In the light of these improved metrics (Table 1), it becomes evident that the market is clearly undervaluing Suncor, even though its reserves and daily production are more valuable than its competitors and despite capitalizing on the price differentials that the industry is suffering from.
Table 1: Relative Valuation
Reserves and Operations
Suncor has the largest reserves among its peers with one of the highest oil content (Table 2). Suncor also has the highest exposure to oil sands and has a steady non-oil sands business. Suncor's upgraders and refineries also have one of the highest capacities and this is truly a testament in Suncor's highest EBITDAX margins.
Table 2: Reserves and operational characteristics
Source: Company reports
Suncor's operations are divided into four business segments namely Oils Sands, Exploration and Production (E&P), Refining and Marketing, and Corporate, Energy Trading, and Eliminations (Figure 1).
Figure 1: Suncor's revenue and earnings breakdown
Source: Suncor's 2011 report
Oil Sands include the operation in northeast Alberta to develop and produce synthetic crude oil (SCO) and related products, through the recovery and upgrading of bitumen from mining and in-situ operations. Suncor also has 12% stake in the Syncrude oil sands mining and upgrading venture. Oil Sands average production was 304,700 barrels of oil equivalent per day (BOED) in FY2011. The company also owns and operates a pipeline that transports synthetic crude oil from Fort McMurray to Edmonton.
Exploration and Production includes E&P of conventional crude oil, natural gas and natural gas liquids in Western Canada, offshore activity in East Coast Canada, with interest in Hibernia, Terra Nova, White Rose and Hebron oilfields, and the E&P of crude oil and natural gas in the UK, Norway, Libya and Syria. In FY2011 this segment contributed 206,700 BOED which included 128,459 barrels per day (BPD) of oil. Suncor's Syrian assets (7.6 MBOED in FY2011) are still suspended as a result of the political unrest and international sanctions against Syria. Libyan assets are currently under operation and produce an average of 12,100 barrels of oil per day.
Refining and Marketing includes the refining of crude oil, distribution and marketing of these and other purchased products through refineries in Edmonton, Montreal, Sarnia, and Commerce City in Colorado, with a total refining capacity of 455,000 bpd. Suncor also owns a lubricant plant. Suncor's inland refineries (Edmonton, Sarnia and Commerce City) were very profitable due to wider discount for WTI compared to Brent. The integration with oil sands reduces the feedstock costs for refineries.
Corporate, Energy Trading and Elimination includes third-party energy supply and trading activities and activities not directly attributable to an operating segment. It manages investment in wind energy projects and develops strategies to reduce greenhouse gas emissions. Energy supply and trading activities involve marketing and trading of crude oil, natural gas, refined products and by-products, and the use of financial derivatives. Suncor's renewable energy interests include six wind power projects (255MW) and Canada's largest ethanol plant by production volume (400 million liters per year).
Suncor's profitability is a function of high crude oil production, reliability of upgraders and refineries, and the existence of price differentials. A lack of any one of these factors would negatively impact Suncor's bottom-line as it did in 2012 Q4 when its upgraders experienced operational issues. Suncor's strategy includes leveraging its integrated model to capitalize on the price differentials and realize higher margins on each barrel of oil. The company upgrades (92% in FY2012) most of the mined bitumen into SCO, which has traded at premium to WTI. Suncor also refines the third party crude oil to realize the premium Brent Prices for its refined products. The company targets $35 production cost per barrel in oil sands in the short-term while increasing production to one million barrels of oil equivalent by 2020. Company's corporate strategy includes focusing on crude oil production from oil sands and conventional means, and divesting non-core assets including excess natural gas due to prevailing low prices for natural gas.
Harness low cost in-situ operations and reduce costs:
Figure 2: Increasing production from low-cost in-situ operations
Source: Suncor's 2011 and Q4 2012 reports
Currently, about 60% of Suncor's oil-sands production comes from open-pit mining and the rest from in-situ operations. In the medium term (Figure 2), in-situ operations will contribute about 60% of oil-sands production. In-situ operations typically cost 30% less and this will reduce overall oil sand production costs by 25%. Increasing in-situ operations is probably the basis of Suncor's ambitious cost target of $35 per barrel in oil sands. As highlighted in Suncor's 2011 Annual Report, 10 year growth strategy plan, which includes continued development of stages four through six of the company's Firebag in-situ project and development of a second stage of the MacKay River in-situ project will increase in-situ production. The ramp up in Firebag 4 project would drive Suncor's in-situ growth in the short to medium term.
Capture WTI-WCS and Brent-WTI differentials:
Suncor upgraded over 90% of its oil-sands production to higher valued SCO. The refinery throughput was close to 100% of its upgraded and conventional crude, which in turn is about 94% of its total production. Hence, Suncor has been creating value by converting low priced oil sands oil into SCO and then into Brent priced refined products all in-house. With the reversal of Enbridge's Line 9, even Montreal refinery will be able to capture the WTI-Brent differential, further increasing the profitability.
Suncor's profitability in different scenarios:
Table 3: Suncor's profitability = function (price differentials)
In the high differentials scenarios, Suncor's close-knit integrated model will yield abnormal earnings. Suncor upgrades a majority of its oil sands production to SCO. Suncor also refines an amount close to its total refinable crude to realize even higher Brent prices. Hence, Suncor's profitability, assuming everything else remains same, will be the highest during high differential scenario.
In the low Brent-WTI differential scenario, which could happen with more pipeline infrastructure, stagnant/reduced US domestic production and inhibited growth in oil-sand production, Suncor will still yield high sustainable earnings. When Suncor's oil sands production exceeds its refining throughput, its oil sands production would be sold at a higher price but refineries' profitability would reduce with the shrinking Brent-WTI differential. However, even before that happens, Suncor's oil sand production would dwarf its refining capacity.
Suncor's competitive advantage is a function of
- Crude oil rich (95%) oil reserves
- Oil-sands integrated Upgraders
- Oil-sands integrated Refineries
- Economies of scale
It is highly capital and time intensive to replicate Suncor's model, which has the best at every stage of the value chain. Hence, Suncor's competitive advantage is sustainable.
The Canadian oil and gas industry is being driven by the continued growth in the oil sands production in the land locked Western Canada. The US has been the single biggest customer of Canadian oil; however, the trends pertaining to US domestic production, pricing and imports of Canadian crude oil are alarming at the moment.
Canadian crude oil crowd in the US enables Suncor to capture Brent-WTI differential:
Figure 3: US domestic production and net imports trend
Source: Dept of Energy data sourced from Bloomberg
The US Midwest (PADD-2) is currently Canada's largest market (2.7 million barrels per day) due to its close proximity, large size and established pipeline network. However, this historically attractive market is now saturated as evidenced by the large buildup of inventories from growing domestic production and imports from Western Canada. As a result of strong production in both the US and Canada, pipeline capacity has become a bottleneck. As shown in figure 3, since September 2012, domestic production in the US has increased by over 11%, net imports by the US have reduced by over 23%, and the Canadian exports to the US have declined by over 8%. These trends will continue to put downward pressure on West Texas Intermediate (WTI) and widen the gap between WTI and Brent prices. This augurs good for the companies that upgrade bitumen and for those that refine crude. Suncor is in a unique position to capitalize on this opportunity by realizing premium to WTI for its upgraded SCO and realizing Brent prices for its refined products.
Suncor's upgraders help capitalize on the widening WTI-WCS differential:
Figure 4: Widening Canadian crude differential
As shown in figure 4, Canadian heavy crude oil, benchmarked by Canadian Western Select (WCS), has always traded at discount to WTI. The differential has grown from $5.5/barrel (2009) to $42/barrel (2012). The discount as a percentage of WTI has also risen from 15% in 2009 to 36% today. While the incremental costs associated with processing the heavier and sulphur-rich Canadian crude is approximately $6 per barrel, the prevailing differential demonstrates the departure from the fundamentals. This trend also justifies upgrading bitumen to SCO, which trades at a slight premium to WTI.
Rising shale oil production in the US to increase Suncor refineries' profitability:
Permits are being issued in the US shale plays (Bakken formation, Permian Basin, Eagleford shale play, Ohio, and Utah) in large numbers. If the track record of Bakken formation is considered representative, US shale formations can contribute up to 2.8 million barrels of oil per day in the short to medium term. This will likely put downward pressure on already depressed WTI prices. The more depressed WTI vis-à-vis Brent, the greater the profitability of Suncor's refineries. Moreover, since Suncor upgrades most of its oil sands production to SCO, its oil sands business will be less impacted by the depressed WTI compared to its peers. Overall, Suncor's profitability will be higher than its peers even with more shale oil coming to market.
Price of Suncor's SCO would increase with increasing US demand for Diesel:
Figure 5: Growing diesel demand in the US
Source: American Petroleum Institute data sourced from Bloomberg
Diesel demand has been increasing whereas gasoline demand has been reducing in the US (Figure 5). The refineries in the US are designed to yield more gasoline than diesel. Increasing demand for diesel has been creating a shortage of diesel. Since refining a barrel of SCO yields more diesel than WTI, it is likely that demand for SCO would increase. This will sustain or increase the premium that SCO commands over WTI. This trend will continue to benefit Suncor that upgraded 92% of its oil sands production into SCO.
New markets for Canadian crude:
Midwest refineries to increase capacity for heavy oil: A number of refineries have announced projects designed to increase the heavy oil processing capability; however, there have been some delays in their start-up due to the growing availability of domestic light oil.
Eastern Canada: In 2011, Eastern Canadian refineries imported over 680,000 bpd (85% of requirement) from offshore foreign suppliers at Brent prices.
US Gulf Coast: In 2011, the U.S. Gulf Coast refineries, designed for heavy crude oil, imported over 2.4 million barrels per day (MMBBLD) of heavy oil from Mexico, Venezuela, and Columbia at a premium to WTI. Imports from Mexico and Venezuela have been reducing due to declining production, increasing refining capacity and exports to China. Deliveries of western Canadian crude oil to this market totaled just 112,000 bpd, almost all of which was transported through the Exxon Mobil Pegasus pipeline. US Gulf is in desperate need of fairly priced and consistent supply of heavy crude. Western Canada will be able to export up to 1.2 million barrels per day to the US Gulf in the medium term. Seaway Pipeline became operational in Jan 2013 and has increased capacity from 100,000 to 400,000 bpd. Permit Express pipeline will add 90,000 bpd by 2013. Keystone XL, whose southern part is already in construction, will bring a minimum of 700,000 bpd to the Gulf Coast.
These pipelines will reduce the oversupply in the Midwest, and put upward pressure on WTI. Access to the US Gulf coast is strategic for Canadian oil companies because even with the US becoming energy independent, the Gulf Coast could act as a conduit for Canadian oil to Caribbean countries.
China: In 2011, China imported about 5.7 MMBBLD of oil. The Kinder Morgan project would allow for the shipment of another 890,000 barrels a day between Edmonton and Burnaby, B.C., where it connects to a dock that stands to be an important outlet for Canadian oil to find new buyers in California and Asia.
Suncor's profitability will increase with more pipeline capacity:
Figure 6: Suncor's oil sands production and refining throughput
Source: Suncor's 2011 and Q4 2012 reports, and projections
When Canadian crude finds access to alternate markets, the glut in the US Midwest would reduce and WTI will experience an upward pressure vis-à-vis Brent. While this would result in higher price realization for SCO and potentially bitumen, refineries will make slightly less as the gap between Brent and WTI would contract. All else equal if the proposed pipeline capacity comes online today, Suncor would gain $1 per barrel in oil sands business but would lose $1 in refining. Since Suncor currently refines more crude than it produces in oil sands (Figure 6), contracting gap between Brent and WTI would hurt the bottom-line even though the overall profitability would still remain higher than its peers. However, this force will take at least 2-3 years to become prominent and by then Suncor's oil sands production would have exceeded its refining capacity. Hence, increasing WTI would make oil sands relatively more profitable and refineries slightly less profitable; Thus, Suncor's overall profitability would further improve. The differential between WTI and WCS would reduce and this would reduce the incentive for other companies to upgrade bitumen and any oversupply of SCO from Canada would potentially be contained.
Figure 7: Suncor's oil sands' profitability relies on its upgraders
Source: Suncor's 2011 and Q4 2012 reports
The biggest risk to Suncor is the unreliability of its upgraders. During upgraders' downtime, Suncor has to sell at oil sand production at WCS (discount to WTI). In Q4 2012 downtime in Suncor's upgraders led to huge decline in oil sands' profitability (Figure 7). The opportunity cost of not upgrading is about $5.5-$8M each day.
Oversupply of upgraded Bitumen from oil sands could also reduce SCO-WTI differential.
Underfunded defined benefit pension plan: Suncor's underfunded defined-benefit pension plan is not of significant concern as short-term risk defined as (Plan Obligations-Plan Asset)/market cap is only 2% whereas long-term risk defined as (Plan obligations/market cap) is only 7%. These risks levels are way below risky levels.
Other Risks: Royalty increases, Labor shortage, depressed differential (WTI vs. Brent), Environmental concerns, and Currency Risk.
Figure 8: Contribution of segments to Suncor's Valuation
Suncor has been valued using Sum-of-Part methodology. The valuation methodology involved DCF-NAV approach for the upstream and oil sands production business, and the trading comparable approach for the remaining parts of the business. Suncor derives most of its value from its oil sands business, and refining and marketing business (Figure 8).
Valuation assumes long-term commodity forecasts for $90/bbl WTI, $95/bbl SCO, $103/bbl Brent, $80/bbl WCS, and AECO of $4/mcf. The model assumes that Suncor's oil-sands upgraders operate reliably with no major downtime so that Suncor continues to command a small premium to WTI for the upgraded SCO. The growth in in-situ operations would stabilize the average cash operating costs to $32 per barrel, $2 more than Suncor's 2012 average cash operating costs. Industry standard after-tax discount rate of 10% is used because most of Suncor's assets are in stable jurisdictions. Suncor's $50 billion in CAPEX since 1992 and its $7.5 billion of 2012 CAPEX were anchored in the costs to develop its proven and probable reserves. Since only 31% of Suncor's proven reserves are undeveloped, $28.35 billion was taken as the costs to develop its proven and probable reserves. Contingent reserves were not factored in the valuation due to high certainty in the production costs and reserves.
Suncor Energy is uniquely positioned to capitalize on the prevailing price differentials, constrained capacity, and low natural gas prices. Suncor is the biggest producer of crude oil in Canada with the biggest exposure to oil sands. Suncor's highest capacity to upgrade bitumen and the ability to refine is paying off in terms of higher profitability. As shown in the analysis above, even when more pipeline capacity comes online and price differentials reduce, Suncor's profitability would still be higher than its peers because by then Suncor's production would have exceeded its refining capacity. With the growth coming from low priced in-situ operations, Suncor's oil sands production costs are set to further decrease. With experienced leadership and oil-rich reserves, Suncor is way ahead of its competitors and well positioned to create value for its shareholders. Suncor is especially a good buy currently due to the depressed share price due to the impairment charges of Q4 2012.
For valuing the refining and marketing segment, comparable companies were found based on the capacity, throughput, geography, revenue and EBITDA. For valuing the renewable energy business, a TSX-V listed company was considered a proper comparable based on the similar asset base (wind farms) and jurisdiction.
Ratio Analysis (After reversing for the capitalized interest charges)
Big Bath suggesting better future earnings:
Suncor's open market share repurchase plan lacks the minimum materiality threshold of 5% to cause any appreciable share price appreciation. I believe that Suncor is doing this to just return money to shareholders and with no intention to boost the share price. These buy-backs were funded by cash, which increases the firm's net leverage.
Suncor's upgrader and refinery throughput
Suncor's Proven and Probable Reserves:
Additional disclosure: I am a full-time MBA student at Rotman University of Toronto. Following oil and gas sector is my passion and the work presented here is solely mine.