Investors willing to act on a longer time horizon than the stock market and willing to take an objective view on environmental consequences might look again at buy-recommended Canadian Oil Sands Trust (OTCQX:COSWF). A favorite income stock in the last cycle, now at US$23 a unit, we expect COSWF to exceed its old high of US$56 a unit, as sound stocks usually do, eventually.
Of course, we are quick to point out that the stock might not do so well if everything falls apart in the global economy. “That has already happened!” an astute client was quick to retort recently when we added our qualifier. Taking the same constructive approach, we update our discounted cash flow model that supports our current estimate of Net Present Value (NPV) of $US 42 a unit. Naturally, the estimate is sensitive to oil price, currency rates, natural gas price and expected rate of return among many factors, some of which we discuss. At the same time we reexamine our conclusion that high-quality synthetic crude oil is a more attractive fuel environmentally on a complete basis than perhaps half of the world’s energy supply.
Long-Life Resources Keep Giving
The most visible investment advantage of oil sands is that once the resource is outlined and the infrastructure is up and running, production can continue for a long time at a constant rate with minimal upkeep and at moderate operating cost. The initial capital cost for an oil sands mine and upgrader is high. Facilities are necessarily large to take advantage of economies of scale. The Syncrude venture (36.7% COSWF) at capacity of 350 thousand barrels daily is the energy equivalent of 9 giant 1000 megawatt nuclear power, or coal plants. An important distinction for COSWF is that the investment in current capacity has been made and the valuation challenge is to determine what the product of that investment might be worth.
The discounted cash flow technique is standard analysis. COSWF discloses in its Annual Information Form filed with the regulators in Canada the results of calculations by its independent engineer. We translate those results to NPV of about US$38 a unit, assuming a 10% yearly unlevered return, or US$75 a unit assuming a return of 5% a year. The calculation depends on many variables, some of which are disclosed explicitly. Rather than interpreting further the engineer’s calculation we offer our own simple model (see table below, Present Value of Future Cash Flow). If you want to skip the numbers, go to the next section, Clean Oil Sands. Understandably, changing the variables will change the outcome. Here are some results from changing the variables in the cells bordered by a box outline:
Increase oil price by US$5 a barrel and NPV increases $5 a unit.
Increase the Canadian dollar by ten cents and NPV decreases by $3.
Reduce natural gas price by US$5 a million btu and NPV increases $4.
Increase discount rate by 1% and NPV decreases by $5.
The first row in the projections is what we are currently expecting for the next twelve months for revenue, production cost and natural gas cost. After that we keep everything constant at a level intended to approximate a steady state equivalent. Since there is no adjustment for inflation, the discount rate is also a return before inflation.
The calculations ignore corporate income tax for two reasons. First, the analysis is from the point of view of a buyer or investor in the properties whose taxable position is unknown. Second, Canadian corporations do not usually pay much cash corporate tax on oil and gas operations.
Having visited with management twice last month, we are reasonably current on further details. There are also rather complete relevant discussions in the Annual Report and Annual Information Form just released.
Clean Oil Sands
Visualize world energy supply as one-third coal, one-third oil and one-third natural gas, nuclear and hydro. Along the clean spectrum, coal is at one end, oil in the middle and natural gas at the other end. Oil sands, part of oil supply, is between coal and conventional oil on the clean spectrum. Fudge-like oil sands are not solid, like coal, or fluid, like oil. The physical consistency coincides with inherent characteristics that make oil sands cleaner than one-third of world energy. Local resource management practices can also make a difference. Because of Canada’s high environmental standards, we rate Canadian oil sands as cleaner than half of world energy supply.
We believe in strict environmental standards. From a selfish point of view, the stricter the better. But we also have to be fair. Developing countries have a different tradeoff between clean and economic progress. We can’t in good conscience shut down all the world’s coal plants for environmental reasons. As long as coal is a serious polluter in China and the U.S. among other countries, we need to be balanced in imposing restrictions on cleaner fuels such as synthetic crude oil and refined oil products.The U.S. generates half of its electricity from coal. Clean coal is the likely answer, but it would come slowly because it is expensive. Economies of scale can help.
During the late 1960s when we were studying the outlook for energy in a rising price and increasingly environmentally conscious economy, we visualized giant coal-based industrial facilities that converted some coal to liquid, some to natural gas, removed pollutants at the molecular level and used the waste heat for electricity and industrial processes. We were not thinking about carbon dioxide at that time, but it could be handled too, for a price. We were also optimistic about the future for tar sands as we knew the resource then.
In the ensuing forty years we see that the coal facilities were built-----in South Africa. Otherwise clean coal has been a bust in the U.S. with one gasification facility in North Dakota. At the same time, tar sands, now oil sands, has been a great economic success as the costs have been reduced to competitive levels. In other words, clean coal is still a dream, but clean oil sands have become a reality. If clean coal is in our future, we’ll increasingly appreciate the superior economics of clean oil sands.
Oily Demise for 1600 Ducks
Despite the relative cleanliness of oil sands, accidents happen. An unfortunate accident in February claimed the lives of migratory birds that landed on a tailings pond at Syncrude. Water used to separate bitumen, the raw hydrocarbon material, from sand is then recycled through settling basins where the sand separates. Though the surface of the ponds may be safe enough, it becomes deadly when a duck dives under water into an oily mixture and drowns. Normally, noise generating cannons keeps the birds at a safe distance and we are not aware of any such serious duck kills in the past thirty years. The accident this winter occurred when waterfowl migrating earlier than expected were drawn to the Syncrude ponds while surrounding bodies of water were still frozen. Apparently the noise cannons had been disabled by a snowstorm and Syncrude’s migration tracking system was inaccurate.
Announcing changes to its waterfowl protection program, Syncrude chief executive, Tom Katinas, acknowledges, “Our stakeholders expect the very best from us when it comes to protection of wildlife.” (see International Oil and Gas Newspaper, Upstream, 3 April 2009). A research effort is also underway to find a means for reducing the size of settling basins. One consideration is to use spinning centrifuges to speed the separation of sand and oil residue from water to be recycled.
Originally published on April 10, 2009.