By David McColl
We have modestly reduced the fair value estimates for our covered oil sands producers; CNRL remains a Best Idea.
We recently shifted to a net asset value, or NAV, methodology for our oil sands producers, which extends the five-year forecast period we typically use to analyze oil and gas firms to one that we believe more appropriately captures the long development horizons and significant up-front capital requirements of multi -decade oil sands projects. As a result of our updated methodology, we recently lowered the fair value estimates for our covered firms; integrated producers fell by an average of 6%, while the two non-integrated producers on our coverage list, Canadian Natural Resources Ltd. (NYSE:CNQ) and MEG Energy Corp. (OTCPK:MEGEF), saw their fair value estimates fall by 8% and 27%, respectively. Canadian Natural remains our most undervalued oil sands producer and a Best Idea.
Why We Have Updated Our Valuation Methodology for Oil Sands-Weighted Stocks
We believe our former approach to valuing oil sands producers is no longer optimal for capturing the value of the long-life plateau producing nature of oil sands assets. Our former oil sands valuation methodology utilizes a five-year discounted cash flow, or DCF, approach that incorporates an EBITDA multiple-based terminal value. It is in the estimation of the terminal multiple where we believed our methodology could be improved: Given the volatility of market prices and earnings in the oil sands space over the last several years, determining a terminal multiple that accurately reflects the long-term cash flow-generating ability of these projects has proved difficult. By using a net asset value, or NAV, approach, we eliminate this issue.
NAV is a more appropriate methodology for oil sands producers for several reasons. First, the approach is "pure," in that it relies on discounted cash flows over the life of a project. Unlike "traditional" E&Ps, for example, which tend to deploy capital and increase production in a more incremental fashion, oil sands projects are more step-wise in nature, with very long development cycles and production levels that tend to ramp up quickly and then produce at plateau levels for 20 years or longer. In other words, oil sands projects could be viewed as a type of risky annuity. Considering the fact that comprehensive, project-by-project data is available through Canadian regulatory filings, plateau-type production levels lead to fairly accurate long-term modeling. In addition, NAV avoids the use of exit multiples, which can be unduly compressed or inflated given changing industry dynamics such as pipeline congestion and long-term pricing impacts.
The Risked NAV Is Our Fair Value Estimate
The revised fair value estimates for our oil sands coverage list are based on the concept of a Risked NAV, which reflects our forecast of the cash flows from currently producing projects as well as a probability-weighted outlook for future projects. Our Risked NAVs also attribute some value to undeveloped land, but exclude the value of contingent resources in our fair value estimate.
Since our NAVs are driven primarily by future cash flows, there are several factors that will drive an oil sands firm's NAV higher (or lower) as it is recalculated over the course of a project's development. These include the time value of money, sunk costs such as capital spent in the current year, and changes to our commodity price assumptions. Examining the life cycle of an oil sands project--assuming constant commodity prices--provides insight into how its value can change over time. The first phase starts with the exploration and acquisition of a lease. This tends to reflect a low point in valuation, primarily because of a lack of information on the quality of the lease, development plans, and technology. Following the exploration phase is the delineation phase, where the resource potential of a project is estimated. This is a value creation phase. However, what follows tends to have a near-term negative impact on valuation as engineering and regulatory work is undertaken and the first capital is expended. Following these phases is the development or construction phase, where value might vary slightly based upon the capital required to bring a specific project on line. Once construction is complete and production ramps up, increasing cash flow and value creation follow. For an oil sands company, the phases up to commercial production volumes tend to last three to five years. Our base NAV approach captures each of these phases, with the exception of valuing the undeveloped resource, which we believe is not appropriate for our base NAV, as we assume the project will be developed into a commercial operation versus being sold prior to the start of the regulatory process.
Oil Sands Project Valuation (Life Cycle)
In general, we apply risk factors to a project based on its regulatory stage and our overall view of management's ability to execute. Our risk factors reduce the overall project capacity by the risk factor, which in turn reduces total initial capital requirements as capital intensity remains unchanged, but cash flow is reduced.
- 0% long-term value: Risk factor for projects that we consider to have significant uncertainty due to financial or technical risk, in addition to projects that may have been pulled from the regulatory process, or for which insufficient information is available with respect to project timing.
- 25% long-term value: Risk factor for projects that are expected to enter the regulatory queue over the next 12-24 months.
- 50% long-term value: Risk factor for projects that are expected to enter the regulatory queue over the next 0-12 months, or those projects that have been approved but the development timeline remains uncertain.
- 75%-100% long-term value: Risk factor for projects that have been approved and are under development. As the time to first oil approaches we may reduce the risk factor depending on project-specific characteristics.
- 100% long-term value: Risk factor for projects that are currently operating.
Floor Value and Ceiling Value NAV
We also derive two additional NAVs -- Floor Value NAV and Ceiling Value NAV -- that provide boundaries for investors to think about oil sands valuations. We use these NAVs to gauge the potential upside or downside associated with an oil sands company if all its projects were to go on line without any issues (Ceiling NAV), or conversely if its future operations were to grind to a halt (Floor NAV). The boundaries are not used to derive our fair value estimates, nor should they be confused with our "Consider Buy" and "Consider Sell" prices, which are based on our view of the volatility associated with future cash flows of our risked NAV.
The Floor Value NAV, or base NAV, is our view of what investors should be willing to pay for the stock based on currently producing projects, and excluding the value associated with undeveloped reserves and resources and projects in the application phase but not yet under construction; projects under construction are risked at 0%-50%, depending on timing to first oil.
The Ceiling NAV, or unrisked NAV, is our view of what investors should be willing to pay for the stock if all projects were developed as planned and its undeveloped acreage and contingent resources were fully valued (or sold) based on reasonable market prices.
What Is the Impact of Our Updated Methodology on Our Fair Value Estimates?
The fair value estimates for our oil sands producers have been reduced as a result of applying our updated methodology. However, the impact is relatively minor, at less than 10%, on average. MEG Energy is the exception, as its fair value estimate is significantly reduced owing to meaningful capital investment in 2013. However, we expect to observe an increase in MEG Energy's fair value estimate, from CAD 35 to CAD 42 per share over the next two quarters, as additional phases at its Christina Lake oil sands project come on line and capital spending falls, increasing future free cash flow.
Valuation Changes for Morningstar’s Oil Sands-Weighted Producers
Note: All prices are in Canadian dollars. Source: Morningstar
CNRL Remains a Best Idea
Canadian Natural Resources Ltd. remains a Best Idea within our Canadian oil and gas coverage universe. We continue to favor Canadian Natural because of its significant undeveloped oil sands resources, expected production from the Kirby project in 2014, ongoing reliability improvements at the Horizon oil sands mine, and its existing portfolio of onshore and offshore assets. On a valuation basis, it remains the most heavily discounted to its fair value estimate, at 30%. Furthermore, we like the potential improvements that could accrue to shareholders as the company brings new projects on line. One way to measure this is by looking at how the fair value estimate could increase by CAD 20 per share from 2012 to 2017. In addition, we like the potential for significant improvements in the company's return on invested capital, from 5% in 2012 to a projected 12% or so in 2017. Within our coverage universe, only MEG Energy could experience greater ROIC and NAV improvements over a similar time frame. Canadian Natural, however, has the most potential as measured by its discount to fair value.
MEG Energy Corp.
We have lowered our fair value estimate by 27% to CAD 35 per share, from CAD 48 per share. Despite the material reduction in valuation, we believe MEG Energy has significant potential going forward as production from new projects at Christina Lake and Surmount should support an increasing NAV. Any delays or execution problems could put downward pressure on the share price for this emerging oil sands producer.
Canadian Oil Sands Ltd.
We have lowered our fair value estimate by 8.7% to CAD 21 per share, from CAD 23 per share. We believe Canadian Oil Sands (OTCQX:COSWF) will have sufficient cash flow to maintain its current dividend. We believe its 7% yield could result in the stock trading at a premium to its NAV--buoyed by investors seeking yield--although we don't foresee any significant production growth over the next decade, as its only asset is the Syncrude Joint Venture.
Cenovus Energy Inc.
We have lowered our fair value estimate for Cenovus Energy (NYSE:CVE) by 2.4% to CAD 41 per share, from CAD 42 per share. Cenovus has more than a dozen potential in situ projects in various phases, and it remains one of the lowest-cost SAGD producers, from the perspective of operating and initial capital costs.
Husky Energy Inc.
We have lowered our fair value estimate for Husky Energy (OTCQB:HUSKF) by 3.1% to CAD 31 per share, from CAD 32 per share. Over the past several years, Husky has been successful in turning around not only its operations, but also the performance of its Tucker oil sands project. This leads us to believe that its Sunrise project (first oil in 2014) will be a success. In addition, we look for stronger earnings from its downstream operations as internationally sourced, high-priced barrels are replaced with lower-cost, domestic feedstock. First gas from its Liwan project is expected next year, and we do not see any reason Liwan would be delayed.
Imperial Oil Ltd.
We have lowered our fair value estimate for Imperial Oil Ltd. (NYSEMKT:IMO) by 5.9% to CAD 48 per share, from CAD 51 per share. Despite some significant bumps along the road as it developed the Kearl oil sands mine, Imperial Oil remains one of the top integrated producers within its peer group. We look for first sales from the Kearl project in the third quarter with sales and production ramping up throughout the year. Toward the end of 2013 or early 2014 we'll look for Imperial to provide additional information on its proposed Aspen in situ project.
Suncor Energy Inc.
We have lowered our fair value estimate by 9.6% to CAD 47 per share, from CAD 52 per share. Despite the reduction in its fair value estimate, we continue to view Suncor (NYSE:SU) as the premier integrated producer in Canada. Its refining margins are superior to its peers, which is key to its success as its in situ oil sands projects are higher-cost relative to some of its peers. Going forward, we look for continued execution of its growth projects, including de-bottlenecking of its oil sands complex and the possible addition of a coker at its Montreal refinery.