Suncor Energy Inc: My February Long Pick

Feb.28.14 | About: Suncor Energy (SU)

I set out at the beginning of this year to pick and cover a company each month, which meets my criteria for a good long-term investment. This is not meant for those looking for the quick trade based on short-term momentum, but for people looking to invest for the longer term and looking for steady gains, with little danger of a complete wipeout. It is a guideline to companies with a business model that is resilient in the face of what I believe to be a long period of slower global economic growth for the next few decades and more volatility than experienced in the past.

Last month I picked Kimberly-Clark Corporation (NYSE:KMB), which provides products such as adult diaper through brands like Depend. Within the current global economic and demographic long-term trends context Kimberly-Clark offers an opportunity for an investment with little potential downside. Products such as disposable diapers tend to have staying power in a market, once culture adopts widespread use of these products. As for continued market penetration, these are products which the growing middle class in the developing world tend to spend their increased spending power on before many other comfort-enhancing products. It therefore makes perfect sense to regard it as a good long-term buy & hold stock.

For this month, I chose Suncor Energy Inc (NYSE:SU). Before I turn to covering the company itself, I want to point out a few general factors affecting companies heavily invested in Canadian oil sands. Currently, the transport bottleneck affecting producers is pushing down the price of synthetic crude produced in Canada to a level which makes production activities barely profitable. The WTI-WCS spread is currently -25 dollars per barrel (link). Whether it will be the Keystone XL pipeline or another solution, this bottleneck is temporary in nature, therefore the current discount will not affect long-term value of these companies as much as short-term stock trade might suggest. I think the current bottleneck situation is in fact an opportunity to start building a position in Canadian oil sands.

Given many of the global developments around the world in the oil industry, Canadian oil sands operators are obvious contenders for safe bets in the oil industry. Tim Dodson, in charge of exploration at Total SA (NYSE:TOT) was quoted as saying that global conventional oil discoveries in 2013 were at the lowest level since 1995 and that he expects poor results to continue going forward (link). For many years now, the industry has been trying very hard to replace reserves depleted by yearly production, with no success in doing so through new discoveries. It is no secret that conventional oil production has been flat for almost a decade already. The cheerful reports on ever growing reserves, which led us into current complacency are based on two main factors. The first and most important is the continued booking of unconventional reserves, which do not really need to be discovered, just find the right technology to tap it at the prevailing market price. The second source of reserve growth has to do with increasing recovery rates in conventional oil fields, due to the one-time effect of the 500% jump in oil prices since the year 2000.

The price increase we saw last decade should not be counted on to materialize again. As I pointed out many times before, demand destruction effect tends to put an end to oil price increase at the $110-120 per barrel level for WTI.

Note: As price of WTI crude advanced past $110 per barrel in the spring of 2011, it caused a massive drop in consumption in OECD. It was the last attempt for price to rally past $110 for a sustained period.

Further price increase may be needed to make a further increase in conventional field recovery rates viable, but this increase is unlikely to happen. Canadian oil sands production on the other hand is viable and profitable at current price level, even with the WCS discount in place and there is no reason to believe that there will be a dramatic rise in production costs going forward. A recent Bank of Nova Scotia study shows that Canadian oil sands production is profitable in the $60-65 per barrel range, which is significantly cheaper to produce than US shale oil (link). With all other sources of oil and liquid fuels on an increasing production cost path, Canadian oil sands is clearly the best long-term oil upstream play.

Why Suncor?

Now that I established the superior aspect of Canadian oil sands as a long-term investment compared to other oil commodity plays, I should explain why I believe Suncor Inc is a good investment within the sector. Suncor's experience as a company in the oil sands extraction business is one such aspect. Suncor is one of the original pioneers and as such is arguably among the most capable in withstanding shocks. After all, Suncor was there long before oil prices rose to a new normal price level, which is roughly 500% higher than the long-term average before the year 2000.

Suncor is to be favored in my view over other companies involved in oil sands extraction, because unlike many other companies involved in the field, it does not have significant exposure to other oil & gas extraction fields, therefore when it comes to upstream operations, it is more or less a pure oil sands play, with only a relatively small proportion of production coming from other sources. As graph shows, most future production comes from oil sands, and according to latest production data from q4, 2013 report, about 70% of current oil & gas production volume is Canadian oil sands.

Click to enlarge

Source: Suncor Presentation 2013

As the graph above shows, Suncor is likely to achieve production growth of about 350,000 barrels per day from 2012 levels, by 2020. That is a roughly 55-60% increase expected to be achieved on current production of 558,000 barrels of oil equivalent per day as of the fourth quarter of 2013 (link). Keeping in mind that WCS discount compared to WTI will likely diminish by then, this could mean an 80% increase in upstream revenue compared to 2013. By comparison, in 2013 production declined for oil majors BP, Shell, Chevron and Exxon Mobil as I pointed out in a previous article (link). As Suncor continues to improve on operation efficiency, net earnings growth could be more impressive than revenue growth in the upstream segment of operations.

There is no reason to believe that production, thus revenue growth will not continue to grow beyond 2020 either. Oil sands reserves will not run out any time soon. Suncor Energy is sitting on a total reserve base of proven, probable and contingent resources of over 23 billion barrels, with almost 7 billion barrels in the proven and probable category. Some portion of that total of 23 billion barrels may not be realized, but even so, between 2013 and 2020, Suncor cumulative production will total about 2.2 billion barrels, which means that the reserve base will not come close to being exhausted.

Long-Term Valuation:

Current Exxon Mobil (NYSE:XOM) market cap is about $417 billion, based on production of 2.24 mb/d of liquids as well as 2.3 mb/d in oil equivalent of natural gas. Production is currently in slight decline and will most likely be lower by 2020 compared with 2013. As evidenced by increased capex spending and falling production, Exxon Mobil production per barrel of oil & gas is increasing. Total oil & gas reserves amount to 25.2 billion barrels (link). Almost half of the reserves are natural gas.

Suncor's market cap is $49.2 billion. As I already pointed out, current production is about 580,000 barrels per day, which is mainly oil. By 2020, production is forecast to rise to about 900,000 barrels per day, and the value of the oil produced should in theory rise about 20% as well, while cost of oil sands production is on a gentle declining path.

Oil sands reserves are booked slightly differently than conventional field reserves of oil & gas, therefore reserve base is slightly harder to compare. While Alberta, Canada claims 168 billion barrels worth of proven reserves, companies operating in the field can only declare a small portion of the resource as proven, based on commitments already made to produce. It is clear however that either through booking more reserves, or acquisition Suncor will not run out of bitumen supplies any time soon, even with the increased production being forecast.

Currently Exxon Mobil market cap is 8.5x Suncor market cap. Production volume is 7.6X larger but half of production is natural gas, which trades at a heavy discount compared to oil. Based on current projections, Exxon Mobil production volume in 2020 will be about 4-5x larger than Suncor production volume assuming Exxon Mobil production volume remain more or less flat, with Suncor most likely continuing to catch up in production volume.

Based on this comparison, Suncor is currently greatly undervalued for the long term. It is important however to understand that it is weighed down heavily by the WCS-WTI discount factor. That is why the fact that current P/E ratio is 11.8 for Suncor (link), while it is 13 for Exxon Mobil (link) is all the more reflective of the fact that there is far more value in a company like Suncor for the long term. This within the context of the oil & gas industry, which will continue to have great value, because continued global oil & gas consumption increase not going anywhere, while opportunities to tap new resources are proving to be hard to find.

Suncor Energy is not the only company worth looking at when it comes to considering investing into the oil sands, but it is the one I find most interesting and safe. What I like about Suncor in particular is its relatively large proportion of upstream operations focused on oil sands, while it is also a relatively large company compared to oil sands peers. Company's long established presence in the field, even during the hard times before oil prices increased to a level that made extraction profitable proves discipline and resilience. Suncor will likely be one of the largest oil sand producers for decades to come, and oil sands will most likely be the most profitable and stable source of liquid fuels going forward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.