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by Mike McDermott

EXECUTIVE SUMMARY:

Social unrest and political shifts in Egypt raise concerns for traditional oil supplies to developed nations.

• Structural changes will have a lasting effect beyond initial protests and potential regime changes.

• As the global economy relies more heavily on oil production outside the Middle East, oil sands developments look particularly attractive.

• Three niche investments are likely to benefit from higher oil prices and increasing demand from non-Middle Eastern producers:

  • Canadian Natural Resources (NYSE:CNQ)
  • Gulfport Energy Corp. (NASDAQ:GPOR)
  • Canadian Oil Sands Ltd. (OTCQX:COSWF)

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The social unrest in Egypt could be the beginning of a much larger shift in the Middle East…

Last week, the world watched as the people of Egypt took to the street and demanded a change of leadership. After decades of of pent up frustration, it was finally time for citizens to be heard.

On the economic front, world markets reacted with higher levels of volatility and a newly embedded fear premium. Oil prices moved sharply higher due to concerns over supply disruptions. Precious metals also caught a bid as investors once again fled to “safe assets” and considered gold and silver to be a stable storage of value.

The rest of the market moved predominantly lower as higher energy prices combined with geopolitical risk makes for a challenging investment environment.

But within a few days of the initial protests, the market began moving higher again. The investment world appears to believe that this regime change can take place peacefully and without causing a major disruption to the global economy. Unfortunately, this may be a bit of a naive assumption…

It’s Bigger Than Just Egypt

A peaceful resolution is certainly more desirable than violence, but either way, an Egyptian regime change is likely to have a much larger effect than most investors currently expect.

Up to this point, Egypt has been a fairly dependable ally for the US and one of Israel’s more friendly neighbors. While the country has its share of problems when it comes to democracy and human rights, there is no denying that Egypt has largely been a stabilizing force in the Middle East.

Of course, with a regime change in the works, it is uncertain what type of leader will be elected or put in power – and by extension, what that could do to the current balance of power in the Middle East. Even a peaceful change of leadership could result in a significant disruption in oil supplies from the Middle East.

So while there is a lot of volatility and uncertainty surrounding the day-to-day events in Egypt, we believe that the big picture will turn out to be largely bullish for alternative energy and non-Middle East sources of petroleum.

Back in September, we noted three uranium opportunities with significant upside potential. Since that report, Denison Mines (NYSEMKT:DNN) has rallied some 130%, Cameco Corp (NYSE:CCJ) is up roughly 60%, and Uranium Participation Corp (U.TO) is up nearly 50%. All three continue to forge new recovery highs and are riding bullish trends as investors scramble to add exposure.

A similar situation is setting up for energy companies engaged in Oil Sands production. This type of oil is heavier and more difficult from an extraction / refinement perspective. When oil prices are low, the higher costs for oil sands keep these resources from being a viable economic option.

But now that supplies have the potential for disruption, and prices are moving steadily higher (which was the case well before the Egyptian turmoil broke out), oil sands are much more appealing. Energy producers can now operate profitably with much less political risk, and investment managers looking for safe places to park their energy allocations will be much more likely to consider oil sands companies.

There are only a few investment opportunities that offer concentrated exposure to oil sands production, and have enough liquidity to make them a viable trading vehicle. But the companies participating in this area are financially healthy with stock patterns that look very attractive.

Below are three actionable oil sands producers which should trade higher as the world adjusts to Middle Eastern leadership changes:

Canadian Natural Resources (CNQ)

The largest producer of heavy crude in Western Canada.

Ample cashflow from natural gas production generates capital available for investing in oil sands production.

Strong balance sheet gives management flexibility in allocating capital to drilling and technology programs.

Oil hedges are expiring, allowing the company to profit from higher spot prices.

Canadian Natural is in the enviable position of having a strong well-established business, while still giving investors potential for significant future growth.

The company is the largest producer of heavy crude in Western Canada. But over the next decade, it will increase production production significantly.

Additions to capacity will be possible for two primary reasons:

1) Drilling expansion – Canadian Natural has a strong balance sheet with ample cash flow and available capital for new drilling programs.

2) Technology advances – As new technology emerges for extracting “heavy crude” Canadian Natural will be the first to take advantage of the opportunities with its access to resources and drilling programs already underway.

Management has flexibility when it comes to ramping up oil sands production because of the strong cash flow the company already enjoys. CNQ currently produces about 1,250 mmcf/d of shale natural gas – generating profits that can be reinvested into long-term oil sands projects. In 2011, the company plans to invest $2.4 to $2.8 billion in new production projects – which will further cement the company’s position as the largest regional producer of heavy crude.

In contrast to large-cap traditional oil producers (which typically have operations in politically unstable regions – or risky deepwater drilling programs), Canadian Natural generates 90% of its production in North America. The lower risk should lead to a higher price multiple once investors become more comfortable with the concept of oil sands production.

The balance sheet is another area that helps investors sleep better at night. CNQ has a debt to equity ratio of 50% which is relatively conservative for the capital-intensive industry. Furthermore, management is committed to paying down debt, so this ratio should improve over the next several years.

I’m particularly impressed with the company’s hedging techniques which have been successful in protecting profitability while avoiding the downside of capping future profits. According to a recent presentation, the company had several “collar” hedging positions that ensured a floor between $60 and $70 per barrel for a significant amount of the company’s production.

The majority of these collars are now expiring, but the price of oil is much higher and continuing to ramp. Management has bought a number of put positions which help to guard against a sharp drop, but CNQ should be able to participate as the price of oil increases.

Trading at roughly 10 times expected earnings, CNQ looks relatively cheap in an uncertain environment for oil supplies. With a strong growth trajectory and minimal risk, CNQ could quickly work its way from the current $45 area up through $80 and even into triple digits. A chart breakout could also catch momentum traders’ attention and add another catalyst for the stock to trade higher (click to enlarge).

Gulfport Energy Corp (GPOR)

Diversified base of assets capped off with a 25% stake in the Canadian Grizzly Oil Sands.

New oil sands production coming online, leading to new sources of profitabiltiy.

Strong financial position creates a growth platform with available capital and a fully funded CapEx program.

• 32% of the company’s production for 2011 is hedged at nearly $87.00 per barrel.

While Gulfport Energy has a fairly diversified portfolio of energy assets, the company’s 25% investment in the Grizzly Oil Sands project should contribute significantly to growth over the next year.

The Canadian oil sands represent a tremendous oil deposit that has until recently been unavailable for production. But with advances in technology, this heavy crude can now be more efficiently extracted and refined, creating a profitable opportunity for companies who have already secured leasehold rights.

According to the Gulfport website, the Canadian oil sands actually rivals the country of Saudi Arabia as the largest known oil play in the world. The sands hold an estimated 315 billion barrels of recoverable reserves and are largely untapped except for a few pioneering firms.

Gulfport offers investors a unique opportunity because of its large stake in the Grizzly project. The entire venture owns 527,609 acres which gives GPOR rights to the equivalent of 131,901 acres. The majority of this property was purchased in 2007 and is just now entering the production stage.

Estimates for the first stage of the project (Algar Lake) put Gulfport’s portion of production at 2,500 barrels per day – a meaningful contribution to the company’s growth.

Similar to Canadian Natural, Gulfport is making good use of its hedging strategies – creating a stable environment for the business while still giving plenty of opportunity to profit from increasing oil prices. For 2011, the company has 32% of its estimated production hedged at $86.96 per barrel. This provides a stable base and with oil prices in a bullish trend, the remaining 2/3 of production will likely be sold at more profitable prices.

In the coming year, Gulfport expects to spend $110 to $120 million on expanding production. This is a significant commitment given the company’s $1.1 billion dollar market cap, but the entire CapEx budget is funded by internally generated cash flow.

With revenues growing at tremendous rates, earnings up an estimated 96% in 2010 and 76% in 2011, and an attractive base of underground assets, Gulfport is in a perfect position to capitalize on higher oil prices.

Investors appear to agree with this assessment as the stock is in a strong bullish pattern and has continued to build on last week’s breakout. While the pattern is a bit extended, the prospects for a continued breakout are good. One strategy for participating at this point would be to buy March $25 calls (with limited risk) on the company and then use any pullback to begin building a position in the stock.

If energy prices remain stable, GPOR has the fundamental chops to command a price in the mid $30′s to low $40′s – and of course if we have a full-on energy crisis, the price could ramp much higher. We will be picking our spots and managing the risk carefully, but GPOR is on my radar list as an attractive oil sands play (click to enlarge).

Canadian Oil Sands Ltd. (OTCQX:COSWF)

• Higher oil prices combined with disciplined cost controls helped the company to beat expectations.

• The company is guiding for significant investment in expansion programs – creating a platform to benefit from higher oil prices.

A low debt to equity ratio allows for flexibility in committing capital to growth initiatives.

Despite some concern over a higher spending budget for 2011, traders responded positively to the company’s Q4 report.

Canadian Oil’s most important asset is a 37% ownership stake in the Syncrude project – an oil sands development in Northeastern Alberta. As the largest partner in this cooperation, COS’ ownership represents 1.9 billion barrels of proven and probable reserves plus an additional 2.5 billion estimated in contingent and prospective resources.

Canadian Oil Sands Process (click to enlarge)

While the process of surface mining and processing the oil sands is very intensive (see production process), the rising price of oil makes for a very economical business model.

Last week Canadian Oil Sands released their fourth quarter earnings report along with selective guidance for the coming year. The company beat expectations handily as higher oil prices combined with lower than expected costs boosted profit margins.

Wall Street analysts turned their nose up at the report, noting a higher level of budgeted capital expenditures for 2011.

But considering the current environment of higher oil prices and better profit margins, it makes sense for the company to be investing in growing production and boosting efficiency.

Traders applauded the report, sending the stock higher in an apparent breakout from a five month consolidation. The final hurdle for the stock will be clearing the $28.50 level which proved to be resistance in early December.

In their most recent investor presentation, management noted that an independent evaluation of Syracrude’s probable reserves, the company should be able to continue current production levels for about 40 years.

Based on the value of underground assets, the current rate of production and profitability, and the company’s distribution plan; the stock price looks relatively cheap. If oil prices remain stable and COS is successful in its efficiency and production improvements, it would be reasonable to expect COS to test the 2009 highs near C35.00.

Of course continuation in the bull trend for oil, and a strong Canadian dollar would act as tailwinds behind this investment.

Canadian Oil Sands trades on the Toronto Exchange but is available for US trading accounts. The company pays a variable distribution to shareholders based on cash reserves and profitability. At this point the yield is just under 3%, and could help to support the stock price as well as attract yield-hungry investors who are also interested in capital appreciation.

Most importantly, the recent earnings report is acting as a catalyst to send shares higher – and could be the jump-start the stock needs to begin a sustained bullish trend (click to enlarge).

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

Source: Strategic Intelligence Report: Opportunities in Oil Sands