Imperial Oil: AAA Balance Sheet And Lower Political Risk Than Integrated Competitors

May.21.14 | About: Imperial Oil (IMO)

Summary

The company offers an Exxon-like balance sheet, but with production growth and long life reserves of 40 years.

IMO, a AAA company, has been ignored by energy bulls with appetites for less diverse drillers operating in costly environments in North Dakota, Australia and the Caspian region.

IMO is held back by short-term worries about Keystone XL pipeline completion, issues surrounding transportation of crude via rail, and environmental opposition to oil sands.

The company has excellent dividend coverage. An inflection point has been reached where operating cash flow (Q1 2014) is roughly 8x or 10x the dividend.

Given a clear path for expanding Kearl from 70K barrels (in Q1 2014) to 345K barrels in 2020, dividends should expand commensurately.

Imperial Oil Ltd. (NYSEMKT:IMO) is one of Canada's largest integrated oil companies. It is involved in the exploration, production and sale of crude oil and natural gas, and is one of Canada's largest petroleum refiners (with 421K barrels of capacity at FYE 2013).

IMO, 70% owned by Exxon Mobil (NYSE:XOM), plans to double its energy output to 600K BOE/day a day by 2020. Based on the growth and the diversity of the business, the shares could see dividend growth to $1.25 per year. Dividend growth could therefore improve by 17% per year, or from roughly $0.49 to $1.25 at the end of the decade.

The company made investments of about $4.5 B during 2013, primarily to progress the development of reported proved undeveloped reserves, especially those associated with the Kearl project. Production from the initial development commenced in the second quarter of 2013. By 2013 year-end, the Kearl expansion project was 72 percent complete.

The company's reputation for operational excellence has been hurt by cost overruns on the first phase of the Kearl project, which is now projected to cost $12.9 billion Canadian dollars (US$11.9 billion), about $5 billion more than originally estimated.

In Q1 2014, gross production from the Kearl initial development was 70K barrels per day (50K barrels Imperial's share). Production continued to ramp up during Q1 2014 as progress was made towards stabilizing production at the targeted rate of 110K barrels per day (78K barrels Imperial's share).

The Kearl expansion project was 72% complete at the end of 2013. The Kearl expansion project remains on schedule for a 2015 start-up and is expected to produce 110K barrels of bitumen per day, before royalties, of which the company's share would be about 78K barrels per day.

Potential future debottlenecking of both the initial development and expansion would increase output to reach the regulatory capacity of 345K barrels of bitumen per day by about 2020, of which the company's share would be about 245K barrels per day.

Oil sands leases have an exploration period of fifteen years and are continued beyond that point by meeting the minimum level of evaluation, payment of rentals, or by production. The majority of the acreage in Cold Lake, Kearl and Syncrude is continued by production.

Kearl and a heavy-oil field called Cold Lake, now under expansion, will account for the bulk of Imperial's production. Part of Imperial's appeal is that these fields have very long estimated reserve lives-up to 40 years.

Growth With Lower Geopolitical Risk

The slide from a recent XOM presentation shows how important Kearl and Cold Lake projects are to the success of XOM going forward. By owning IMO, an investor could avoid political risk in Papua New Guinea, Australia and Russia. All of these areas require extensive government and community consultation, although it must be admitted that Alberta is not devoid of political risk.

How Does IMO Currently Stack Up?

Given the heavy reliance on Kearl, Cold Lake and Syncrude for future cash flows, and that capital spending is at a high for 2014, free cash flow generation in the latter half of the decade is tied to performance of the oil sands business. These are analyzed below.

Average Daily Production of Oil

The company's average daily oil production by final products sold during the three years ended Dec. 31, 2013, was as follows:

2013

2012

2011

Bitumen

142

123

120

Synthetic oil

65

69

67

Liquids

20

18

17

Total

227

210

204

Click to enlarge

Production in thousands of barrels per day, net. All reported production volumes were from Canada.

The company's bitumen production volumes included production volumes from the Cold Lake operation for all years presented in the table above and, beginning in 2013, also included production volumes from the Kearl initial development (16K barrels per day gross, 15K net). This shows how dramatic Kearl will be to IMO in 2017 through 2020 as production ramps up.

Review of Principal Ongoing Activities Other Than Kearl

-- Cold Lake

During 2013, average net production at Cold Lake was about 127K barrels per day and gross production was about 153K barrels per day.

Most of the production from Cold Lake is sold to refineries in the United States. The remainder of Cold Lake production is shipped IMO's refineries and to third-party Canadian refineries.

The Province of Alberta, in its capacity as lessor of Cold Lake oil sands leases, is entitled to a royalty on production at Cold Lake. Royalty rates are based upon a sliding scale determined by the price of crude oil.

-- Syncrude (25% owned by IMO)

Syncrude Canada Ltd. is one of the world's largest producers of synthetic crude oil from oil sands. It has a nameplate capacity of 350K barrels/day, equivalent to about 13% of Canada's consumption. It has approximately 5.1 billion barrels of proven and probable reserves (11.9 billion when including contingent and prospective resources). Including fully realized prospective reserves; current production capacity could be sustained for well over 90 years.

IMO holds a 25 percent participating interest in Syncrude, a joint venture established to recover shallow deposits of oil sands using open-pit mining methods to extract the crude bitumen, and to produce a high-quality, light (32 degree API), sweet, synthetic crude oil. The produced synthetic crude oil is shipped from the Syncrude site to Edmonton, Alberta by Alberta Oil Sands Pipeline Ltd.

In 2013, IMO's share of Syncrude's net production of synthetic crude oil was about 65K barrels per day and gross production was about 67K barrels per day. The company's share of Syncrude's gross production in the first quarter was 73K barrels per day, up from 65K barrels in the first quarter of 2013.

Downsides:

  1. Cost overruns on the first phase of the Kearl project
  2. The company pays a low dividend (current yield is about 1%)
  3. IMO could be negatively impacted by a weaker U.S. dollar: Imperial should be helped by the weak Canadian dollar, now trading at about 92 U.S. cents, since its costs are mainly in local currency and its revenue is linked to the greenback. Earnings in Q1 2014 were higher by $85 million due to the impact of a weaker Canadian dollar.
  4. IMO doesn't hold earnings conference calls and has only limited contacts with investors. Berkshire Hathaway has the same mentality, and Charlie Munger does not consider this a drawback. Investors looking for an edge on Q3 earnings might be dissuaded from owning the shares. Oh well.
  5. Exxon could purchase the 30% owned by minority shareholders. Given the market may anticipate further growth from the Kearl project as 2017 approaches, this buyout may take a large premium. The longer XOM waits, the higher the cost.

Capital Resources

  1. Cash flow generated from operating activities was $1.1B in Q1 2014 due to higher earnings and working capital effects.
  2. Investing activities used net cash of $1.1B in Q1 2014, compared with $2.9B in the same period of 2013 (which included $1.6 B for the Celtic acquisition). Expenditures during the quarter were primarily directed towards the advancement of Kearl expansion and Cold Lake Nabiye projects.
  3. Dividends paid in the first quarter of 2014 were $110 million, $8 million higher than the corresponding period in 2013. Per-share dividend paid in the first quarter was $0.13, up from $0.12 in the same period of 2013.
  4. IMO projects lower capital spending on the Kearl project going forward, along with increasing production. An inflection point has been reached where operating cash flow is roughly 8x or 10x the dividend.

Conclusion

Given the company is shareholder-friendly, has a clear path to doubling production in six years, and is at the peak of capital spending in Q2 and Q3 2014, IMO could reasonably trade in line with S&P 500 names. Remember, less than 3% of the companies in the index have the AAA rating, and many don't have the same growth prospects.

With a market P/E of 17x, and projected 2014 earnings of $3.80, the stock could reasonably see $64.60. Currently the shares trade at $49, indicating an upside of 32%.

Disclosure: I am long XOM. 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.

Disclaimer: The above is not intended to be investment advice, and is only the opinion of the author. Observers may want to consider various oil and natural gas prices, labor costs, and impacts of Arctic drilling activity. Also, with the AAA balance sheet, IMO could borrow significant amounts in various currencies at low interest rates to buy competitors, repurchase shares or pay a special dividend. Any or all of these events would impact the share price materially.